Brainscape's Knowledge GenomeTM

Browse over 1 million classes created by top students, professors, publishers, and experts.


See full index

finance 2 > Capital Budgeting > Flashcards

Capital Budgeting Flashcards

You may prefer our related Brainscape-certified flashcards:
Series 65 flashcards Series 63 flashcards Series 66 flashcards Series 7 Top-off Exam flashcards SIE Exam flashcards CFA flashcards Series 79 Top-Off Exam flashcards
1
Q

What is capital budgeting?

A

Capital budgeting is the process of planning, evaluating, and selecting long-term investment projects which align with an organisation’s strategic goals. It involves the allocation of financial resources to projects with the expectation of generating future cash flows and enhancing the overall value of the firm.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

What is capital budgeting important for?

A

Long-term impact, limited resources, shareholder value, risk management and strategic alignment.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

What are the key components of capital budgeting?

A

1) Cash Flow Analysis (timing and magnitude of inflows and outflows)
2) Cost of Capital (minimum required rate of return to satisfy investor expectations)
3) Risk Assessment (uncertainties and potential risks)
4) Strategic Fit (alignment with firm’s long-term strategy and business objectives)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

What is the cost of capital?

A

Cost of capital is the minimum required rate of return to satisfy investor expectations

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

What is the question both earnings and cash flows are trying to answer?

A

Is the project making the investor better off? By how much?

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

What are the fundamentals of cash flow analysis?

A

1) Only free cash flows are relevant
2) Only incremental cash flows are considered
3) Inflation needs to be considered and treated consistently
4) Investment decisions are independent of the financing method

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

Why are cash flows different than earnings?

A

1) the accrual principle: transactions are recorded when goods have been exchanged, irrespective of the payment
2) matching principle: expenses are reported at the same time at which the related revenues are earned
Hence, neither expenses nor revenues are necessarily reported at the time of the actual cash flows.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

When is the purchase of raw materials and their processing recognised?

A

As an expense (CoGS), only when the sale of the item they have been used for has been completed

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

How are investments recognised?

A

Instead of expenses, they are capitalised into assets.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

How can we evaluate cash flows?

A

We need to undo the changes (due to the accrual and matching principles) that have been made to reach the financial statements.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

What is the first step to undo the changes that have been made to cash flows to reach the financial statements?

A

Undoing the effect of accounting on the gross profit. The key to converting back cash flows is the Net Working Capital.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

What is the key to converting back cash flows?

A

Net Working Capital

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

What is the Net Working capital (NWC)?

A

The NWC is the difference between the operating current assets and the operating current liabilities.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

What does the NWC typically include?

A
  • operating cash
  • inventory
  • accounts receivable
  • accounts payable
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

What is inventory?

A

Levels of stock held by the firm in order to prevent breaks in its operations/sales

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

What is the formula for NWC?

A

NWC = Operating Cash + Inventory + Accounts Receivable - Accounts Payable

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
17
Q

What does it mean if the NWC is positive?

A

Positive NWC represents an investment and, therefore, a commitment of capital and a need for cash.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
18
Q

What does it mean if the NWC is negative?

A

Negative NWC represents a financial resource available to the firm.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
19
Q

What is a cash cycle?

A

A cash cycle is the average time between when a firm pays for its cost of goods sold and when it receives cash from the sale of the product.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
20
Q

What is a short cash cycle related to?

A

A short cash cycle is related to lower NWC and higher FCF.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
21
Q

Why is a short cash cycle related to lower NWC and higher FCF?

A

Because it indicates that the company can quickly convert its inventory into sales and accounts receivable into cash, thus reducing the need for NWC and increasing the amount of cash available for other purposes.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
22
Q

How do we go from profits to cash flows?

A

Tracking what happens to the money received by customers and that is paid to suppliers.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
23
Q

What are the formulas to get the Net Cash Flow?

A

Sales(CF) = Sales (accrual) - ΔA/R
Purchases(CF) = COGS (accrual) + ΔInv - ΔA/P
NetCashGlow = Sales(CF) - Purchases(CF)
NetCashFlow = Sales (accrual) - COGS(accrual) - (ΔA/R + ΔInv - ΔA/P)
NetCashFlow = ProfitMargin - ΔNWC
ΔNWC = ΔA/R + ΔInv - ΔNWC

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
24
Q

What is depreciation?

A

Depreciation is a process of cost allocation. Long-lived assets are purchased in advance but provide benefits over many years. Expenses are recognised as benefit is provided, not at time of acquisition.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
25
Q

How is CapEx related to depreciation?

A

CapEx is the initial cash flow that leads to the depreciation. We need to undo depreciation to retrieve cash flows.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
26
Q

How can the speed of depreciation matter for corporations?

A

Depreciation is an expense charged against the value of the asset. The speed of depreciation can matter for corporations for tax reasons (they want to depreciate it as quickly as possible) and for financial reporting purchases (depreciate slowly to boost profits).

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
27
Q

How can depreciation affect the value of a project?

A

Through the timing of taxes

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
28
Q

How are taxes paid calculated?

A

Taxes = π * EBIT
Taxes = π * (EBITDA - Depreciation)

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
29
Q

True or false: the higher the depreciation the lower the taxes paid.

A

True

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
30
Q

True or false: the higher the depreciation the higher the taxes paid.

A

False

31
Q

True or false: the lower the depreciation the higher the taxes paid.

A

True

32
Q

Is the total amount that needs to be depreciated for a particular asset fixed?

A

Yes, which means the total taxes paid will be the same but their present value doesn’t need to be.

33
Q

What is FCF?

A

FCF is defined as the cash flow that the project would generate if it were all equity financed.

34
Q

What is the FCF formula?

A

FCF = EBITDA - Taxes - CapEx - ΔNWC = EBIT * (1 - π) + Depreciation - CapEx - ΔNWC

35
Q

What is the formula for incremental Cash Flows?

A

IncrementalCF = CFwithproject - CFwithoutproject

36
Q

When computing cash flows what do we need to ignore?

A

Sunk costs and allocated overhead costs

37
Q

Since we are focusing exclusively on the projects cash flows, what happens?

A
  • regardless of financing, we treat cash outflows required for a project as coming from investors
  • regardless of financing, we treat cash inflows as going to investors
  • we evaluate the project as if it were all equity financed
38
Q

What are the investment project selection criteria?

A

1) Net Present value (NPV)
2) Book Rate of Return
3) Payback Period (PP)
4) Internal Rate of Return (IRR)
5) Profitability Index (PI)

39
Q

What is the NPV?

A

The NPV of a project is the sum of the discounted future cash flows to be generated by the project.

40
Q

What is the acceptance rule regarding NPV?

A

NPV > 0

41
Q

What are the properties of the NPV?

A

1) Time value of money
2) NPV depends only on the expected free cash flows and on the opportunity cost of capital (r)
3) NPV is additive
4) The opportunity cost is project-specific and risk-related

42
Q

How is the Book Rate of Return also known?

A

Return on Assets (ROA)

43
Q

What is the formula of ROA?

A

ROA = EBIT(books) / Assets(books)

44
Q

Why is the ROA rarely used?

A

1) it depends too much on how revenues and expenses are clarified
2) its components reflect tax and accounting figures, not market values or cash flows
3) it ignores the time value of money

45
Q

What is the payback period?

A

The payback period is the number of years it takes the company to recover its initial investment.

46
Q

What is the acceptance rule for payback period?

A

Only undertake projects with payback periods less or equal than a pre-specified cutoff period.

47
Q

What are the main disadvantages of the payback period?

A

1) it ignores the cash flows that occur after the pre-specified period
2) it ignores the time value of money and wealth creation

48
Q

What is the Internal Rate of Return (IRR)?

A

The IRR is the discount rate that equates NPV to zero.

49
Q

What is the acceptance rule of the IRR?

A

Only execute a project for which IRR is higher than the opportunity cost r.

50
Q

If borrowing, when should you accept a project when it comes to IRR?

A

r > IRR

51
Q

If lending, when should you accept a project when it comes to IRR?

A

r < IRR

52
Q

True or false: a project can have positive NPV at all possible discount rates.

A

True

53
Q

True or false: a project can have negative NPV at all possible discount rates.

A

True

54
Q

What are the characteristics of the Profitability Index (PI)?

A

1) relevant when there are capital constraints
2) tool for selecting between project combinations and alternatives
3) set of limited resources and projects can yield various combinations
4) highest weighted average profitability index (WAPI) indicates optimal combination of projects

55
Q

What is the formula of PI?

A

ProfitabilityIndex = NPV / Investment

56
Q

What are the shortcomings of PI?

A

1) it doesn’t work that well with constraints other than capital (which could otherwise be invested in the financial markets)
2) when there is more than one constraint or when constraints are intertemporal (on more than one period), more complex methods might be more suitable

57
Q

Is NPV the best approach?

A

No, there are still cases where the NPV doesn’t work that well:
- investments with different maturities or horizons
- investments that can be delayed

58
Q

What is the superior investment appraisal tool?

A

NPV

59
Q

What is the Equivalent Annual Cost (EAC)?

A

The EAC is equal to the yearly cash flow in an annuity that has the same present value as the total cost of the machine.

60
Q

What should we use when evaluating two machines that produce the same output but have different useful lives?

A

EAC

61
Q
A
62
Q

Quando querem as cash flows relevantes de um projeto fazes o que?

A

1) Income Statement
2) Working Capital (NWC = Op. Cash + Inventory + AR - AP)
3) Cash Flow Statement

63
Q

Com a tabela do NWC o que fazes?

A

Trocas os sinais e vai um período para trás

64
Q

Se te dizem que no final do projeto recebes o NWC todo de volta menos por exemplo 5% das vendas porque é unrecoverable:

A

income statement como impairment

65
Q

Quando te pedem as cash flows relevantes de um projeto, o que é que o income statement te dá?

A

EBITDA

66
Q

Quando fazes a tabela do working capital, qual é a ultima linha?

A

a mudança no NWC, não o NWC em si (essa é a anterior?

67
Q

Quando fazes o inventory na tabela do working capital o que fazes?

A

COGS/periodos

68
Q

quando fazes a tabela do cash flow statement pões o que na tabela?

A

ebitda, mudança no NWC, para te dar op. cash flow

69
Q

quando te pedem para recalcular com vat o que acontece ao income statement?

A

nada se nós só quisermos o EBITDA

70
Q

quando te pedem para recalcular com vat o que acontece ao working capital?

A

passas a calcular sales1,23 para accounts receivable, deixas inventory quieto, cogs1,23 para accounts payable, adicionas net vat

71
Q

para onde vai equipment re-sale and depreciation?

A

para o income statement, depois de ebitda para teres ebit

72
Q

se te dizem que pagas algo agora, o que acontece ao income statement?

A

Tens de pôr no periodo 1 e depois no free cash flow tens de por correction (- no periodo 0, + no periodo 1)

73
Q

se te dizem o investimento que tens de fazer, onde poes?

A

crias tabela de investing cash flows que te da o capex

74
Q
A

finance 2 (6 decks)

Brainscape helps you reach your goals faster, through stronger study habits.
© 2024 Bold Learning Solutions. Terms and Conditions