Capital Acquisition Payback Techniques Flashcards
Identify the advantages of the payback period approach to project evaluation.
Easy to use and understand;
Useful in evaluating liquidity of a project;
Use of a short payback period reduces uncertainty.
Under what circumstances would the payback period approach to project evaluation be most appropriate?
- When used as a preliminary screening technique;
2. When used in conjunction with other evaluation techniques.
Describe the payback period approach to project evaluation.
Determines the number of years (or other periods) needed to recover the initial cash investment in the project and compares the resulting time with a pre-established maximum payback period. Uses undiscounted expected future cash flows.
Identify the disadvantages of the payback period approach to project evaluation.
Ignores the time value of money;
Ignores cash flows received after the payback period;
Does not measure total project profitability;
Maximum payback period may be arbitrary.
Identify a technique that is intended to rank capital budgeting projects in terms of desirability.
The profitability index (PI).
Identify five different techniques for evaluating capital budgeting projects.
Payback period approach; Discounted payback period approach; Accounting rate of return approach; Net present value approach; Internal rate of return approach.
Identify the disadvantages of the discounted payback period approach to capital budgeting evaluation.
Ignores cash flows received after the payback period;
Does not measure total project profitability;
Maximum payback period may be arbitrary.
Describe the discounted payback period approach to capital budgeting evaluation.
A variation of the payback period approach that takes the time value of money into account by discounting expected future cash flows.
Will the payback period from using the discounted payback period approach be longer or shorter than using undiscounted payback period approach (to capital budgeting)?
The discounted payback period will be longer than the undiscounted payback period because the present value of cash flows will be less than the undiscounted values.
Identify the advantages of the discounted payback period approach to capital budgeting evaluation.
Easy to use and understand;
Uses time value of money approach;
Useful in evaluating liquidity of a project;
Use of a short payback period reduces uncertainty.
In computing the accounting rate-of-return approach (to capital budgeting), will using the Initial Investment or the Average Investment give the higher rate of return?
Because the average investment gives a smaller denominator, the accounting rate of return will be higher when the average investment is used, rather than when the initial investment is used.
What are the disadvantages of the accounting rate-of-return approach to project evaluation?
Ignores the time value of money;
Uses accrual accounting values, not cash flows.
What alternative investment bases can be used in the accounting rate-of-return approach (to capital budgeting)?
Initial investment; Average investment (i.e., the average book value of the asset over its life).
What are the advantages of the accounting rate-of-return approach to project evaluation?
Easy to use and understand;
Consistent with financial statement values;
Considers entire life and results of project.
Describe the accounting rate-of-return (also called the simple rate of return) approach to capital project evaluation.
Measures the expected average annual incremental accounting income from a project as a percent of the initial (or average) investment and compares that with established minimum rate required.
Identify the disadvantages of the net-present-value approach to capital project evaluation.
Requires estimation of cash flows over entire life of the project, which could be very long.
Assumes cash flows are immediately reinvested at the discount rate.
Describe the net-present-value approach to capital project evaluation.
Compares present value of expected cash flows of project with initial cash investment in project.
Derived by discounting future cash flows (or savings) and determining whether or not the resulting present value is more or less than the cost of the investment
Identify the advantages of the net-present-value approach to capital project evaluation.
Uses time value of money concept;
Relates project rate of return to cost of capital;
Considers entire life and results of project;
Easier to compute than internal rate of return approach.
How is the Net Present Value determined?
It is the difference (net) between the present value of expected cash flows from a project and the initial cost of the project.
Using the net-present-value approach (to capital budgeting), under what conditions would a project be considered economically feasible?
If the Net Present Value is zero or positive, the project is considered economically feasible; otherwise, the project is not considered economically feasible.
Identify the advantages of the internal-rate-of-return approach to capital project evaluation.
Recognizes the time value of money;
Considers the entire life and results of the project.
Under what conditions is the internal-rate-of-return approach (to capital budgeting) not appropriate?
When future cash flows of a project are both positive and negative, the internal rate of return method should not be used because it can result in multiple solutions.
Identify the disadvantages of the internal-rate-of-return approach to capital project evaluation.
Difficult to compute;
Requires estimation of cash flows over entire life of project, which could be very long;
Requires all future cash flows be in the same direction, either inflows or outflows;
Assumes cash flows resulting from the project are immediately reinvested at the project’s internal rate of return.
Compare the internal-rate-of-return (IRR) approach with the net-present-value (NPV) approach (to capital budgeting).
The IRR Approach computes the discount rate that would make the present value of a project’s cash inflows and outflows equal to zero;
The NPV Approach uses an assumed discount rate to determine whether or not the present value of a project’s cash inflows and outflows is positive or not.
