Capital Budgeting Flashcards
what is capital budgeting
the planning process used to determine whether an organisations long term investments are worth funding
what are examples of long term investments a firm might want to spend money on
new machinery replacement machinery new plants new products research and development
how can returns on projects be calculated
initial cash flow
cash flows generated and the times of these cashflows (discount rate)
also consider positive and negative side effects of the project
what externalities currently arent measured in most capital budgeting
environmental costs eg carbon emissions tax
social costs eg child labour, forced labour
need to be forward looking as there could be extra costs associated with these later on
what are the four capital budgeting methods
Net present value
internal rate of return
payback/discounted payback
profitability index
which capital budgeting method works every time
NPV
what is the net present value
present value of all future cash flows minus the initial investment
what is the opportunity cost of capotal
what else could you be doing with this money if it had been put elsewhere
if the NPV is greater than 0 should the project go ahead
yes
if the NPV is less than 0 should be project go ahead
no
a loss of money
if the NPV is = 0 should the project go ahead
indifferent
when choosing between two mutually exclusive projects based only on NPV which should be selected
one with higher NPV
what are the advantages of NPV
recognises time value of money
discounts cash flows not profits
takes into account initial investment size
using NPV maximises firm value
additivity is possible
it can handle non conventional cash flows
why is it an advantage that NPV discounts the cashflows and not the profits
the profits can be manipulated easily
what does it mean that additivity is possible in NPV
NPVs of different projects can be added together
what are conventional cash flows
negative cash flow at time 0
positive cash flows from there on
or vice versa
only 1 change in sign
what does the IRR measure
the profitability of a project by telling you the rate of return you will receive
what is the NPV when calculating the IRR
0
if IRR > k do we invest
yes
if IRR < k do we invest
no
as the discount rate goes up, the NPV
goes down
what are the issues with IRR
- multiples solutions caused by unconventional cash flows
- does not always rank projects correctly
- irr does not differentiate between borrowing and lending
what does the maximum number of IRRs for one project depend on
the number of times that the cash flows change sign from positive to negative and/or negative to positive
what is the payback period
the length of time before you recover from the initial investment
