Capital Budgeting Flashcards
Independent vs Mutually Exclusive
Independent
- screening decisions
- accept or reject
Mutually Exclusive
- preference decisions
- only one among the choices is chosen
Explain
Stages of Capital Budgeting
- Identification and definition stage
- Search stage
- Information Acquisition stage – both qualitative and quantitative information is considered
- Selection stage – choosing projects after cost-benefit evaluation
- Financing stage
- Implementation and Control stage – conduct of post-audit.
Capital Investment Factors
3 Factors (CNN)
- Cost of Capital
- Net Investment
- Net Returns (Net Cash Flows or Net Income)
Net Investments
Outflows less Inflows
Net Returns
Net Cash Inflow (through direct and indirect method)
Direct
- cash inflows less cash outflows
Indirect
- net income + noncash expenses
Capital Rationing
Objective
maximize the NPV of the firm
2-Step Approach in Capital Rationing
- Rank according to Profitability Index
- Choose combination of project with highest NPV
Payback Period
Rule
Accept if ≤ half life
Payback Period
Pros and Cons
Pros
- for evaluating liquidity of project
Cons
- focus on return OF investment rather than ROI
ARR
Rule
Accept if higher than cost of capital
ARR
Pros and Cons
Pros
- evaluate profitability of project
Cons
- uses accrual values rather than use cash flows
Bailout Payback Period
Cashflows + Salvage Value
Payback Reciprocal
2 Conditions to be met
- Payback period is at most half of the economic life of the project
- Net cash inflows are uniform throughout
a non-discounted technique used to estimate a discounted technique (IRR)
Net Present Value
Pro
cost of capital is the reinvestment rate
IRR
Con
IRR is the reinvestment rate
