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Finance > Capital Budgeting > Flashcards

Capital Budgeting Flashcards

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1
Q

what is capital budgeting

A

the planning process used to determine whether an organisations long term investments are worth funding

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2
Q

what are examples of long term investments a firm might want to spend money on

A 
new machinery
replacement machinery
new plants
new products
research and development
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3
Q

how can returns on projects be calculated

A

initial cash flow
cash flows generated and the times of these cashflows (discount rate)

also consider positive and negative side effects of the project

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4
Q

what externalities currently arent measured in most capital budgeting

A

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

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5
Q

what are the four capital budgeting methods

A

Net present value
internal rate of return
payback/discounted payback
profitability index

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6
Q

which capital budgeting method works every time

A

NPV

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7
Q

what is the net present value

A

present value of all future cash flows minus the initial investment

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8
Q

what is the opportunity cost of capotal

A

what else could you be doing with this money if it had been put elsewhere

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9
Q

if the NPV is greater than 0 should the project go ahead

A

yes

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10
Q

if the NPV is less than 0 should be project go ahead

A

no

a loss of money

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11
Q

if the NPV is = 0 should the project go ahead

A

indifferent

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12
Q

when choosing between two mutually exclusive projects based only on NPV which should be selected

A

one with higher NPV

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13
Q

what are the advantages of NPV

A

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

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14
Q

why is it an advantage that NPV discounts the cashflows and not the profits

A

the profits can be manipulated easily

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15
Q

what does it mean that additivity is possible in NPV

A

NPVs of different projects can be added together

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16
Q

what are conventional cash flows

A

negative cash flow at time 0
positive cash flows from there on

or vice versa

only 1 change in sign

17
Q

what does the IRR measure

A

the profitability of a project by telling you the rate of return you will receive

18
Q

what is the NPV when calculating the IRR

A

0

19
Q

if IRR > k do we invest

A

yes

20
Q

if IRR < k do we invest

A

no

21
Q

as the discount rate goes up, the NPV

A

goes down

22
Q

what are the issues with IRR

A
  • multiples solutions caused by unconventional cash flows
  • does not always rank projects correctly
  • irr does not differentiate between borrowing and lending
23
Q

what does the maximum number of IRRs for one project depend on

A

the number of times that the cash flows change sign from positive to negative and/or negative to positive

24
Q

what is the payback period

A

the length of time before you recover from the initial investment

25
Q

what is the cut off period when using the payback rule

A

a date by which you hope to have your initial investment back

if not back by this date, do not accept project

26
Q

advantages of payback

A

easy to use
easy to communicate to managers and stakeholder
quicker profits can lead to quicker promotion for managers?

27
Q

disadvantages of the payback method

A

it ignores the time value of money
difficult to decide the cute off date - arbitrary
receipts after the cut off date are ignored

28
Q

how do we overcome the problem with the payback method ignoring the time value of money

A

discounted payback

future cash flows are discounted to present values

the problem of the arbitrary cut off date still exists

29
Q

what does the profitability index measure

A

the net present value of a project per euro invested

30
Q

how to calculate PI

A

NPV/initial investment

31
Q

what is the decision rule for PI

A

invest if > 0

32
Q

when is PI used

A

when funds are limited or projects are mutually exclusive

33
Q

cashflows not to include in capital budgeting calculations

A 
sunk costs
financing costs (accounted for in discount rate)
34
Q

cashflows to include in the calculations for capital budgeting

A

negative and positive externalities

anything that changes as a direct result

overheads, cashflows

opportunity costs

indirect effects

terminal costs

Finance (12 decks)

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