BEC 3 Capital Budgeting Flashcards
Define Sunk Costs
Sunk costs are those cost that have already been incurred, are unavoidable in the future, and will not vary with the course of action taken.
What is the formula for after-tax cash flow?
(1.0 - Tax Rate) x Pretax cash flows = After tax cash flow
The formula for computing a depreciation tax shield is:
Tax rate x depreciation deduction = tax savings from the depreciation tax shield
What are three general stages in which capital investment cash flows are categorized?
- Cash flows at the inception of the project
- Operating cash flows
- Cash flows from the disposal of the project
What approaches can management take to select the desired rate of return for a project?
- Use a weighted average cost of capital (WACC) method
- Assign a target rate for new projects
- Recommend that the discount rate be related to the risk of the project
Define net present value (NPV)
NPV is the difference between present value of the cash inflows and the outflows from a project.
How are investment decisions made using the NPV?
If NPV is positive, then the investment should be made. If NPV is negative, then the investment should not be made.
What is the profitability index?
The ratio of the present value of net future cash inflows to the present value of the net initial investment. The higher the profitability index, the more desirable the project.
Define internal rate of return (IRR)
The IRR is the discount rate which the present value of the cash inflows equals the PV of the cash outflows from an investment project.
How are investment decisions made using the IRR?
An investment should be made when the IRR exceeds the hurdle rate?
What is the payback method formula?
Net Initial investment / increase in annual net after-tax cash flow = payback period
What is the equation to calculate the PV of $1?
PV = FV / (1+r)^n
where
r = interest rate n = number of years
What is the equation to calc the PV of an annuity?
PV = PMT x (1 - (1/(1+r)^n)) / r
