Capital Budgeting Flashcards
What is capital budgeting?
The process of evaluating long-term investments in tangible or intangible assets, involving significant cash flows and aiming to achieve economic benefits.
What are the key elements of capital budgeting decisions?
Return on Investment (ROI)
Timelines
Time Value of Money
Cash Flows
Discount Rates
Tax Rates
Depreciation Tax Shield
Why is the time value of money important in capital budgeting?
Because a dollar today is worth more than a dollar tomorrow due to its potential to earn returns immediately.
What is the difference between compounding and discounting?
Compounding: Calculates future value based on present value and growth rate.
Discounting: Converts future cash flows into present value using a discount rate.
How does the depreciation tax shield benefit companies?
It reduces taxes by deducting depreciation expenses, resulting in annual tax savings that are treated as cash inflows in budgeting calculations.
Name the tools used to evaluate capital budgeting projects.
Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback Period
Accounting Rate of Return (ARR)
Profitability Index (PI)
What does a positive Net Present Value (NPV) indicate?
The project will earn a return greater than the required rate of return over its life.
How is the Internal Rate of Return (IRR) determined?
It is the discount rate at which the Net Present Value (NPV) of a project’s cash inflows equals the cash outflows, resulting in an NPV of zero.
What is the significance of the Payback Period in capital budgeting?
It measures how quickly the initial investment is recovered from cash flows, with shorter periods being more desirable.
What is the Accounting Rate of Return (ARR)?
The average annual after-tax operating income divided by the net initial investment, providing an accounting-based ROI measure.
What does the Profitability Index (PI) measure?
The ratio of the present value of net future cash flows to the initial investment, helping rank competing projects.
Why is sensitivity analysis important in capital budgeting?
It evaluates how variations in assumptions (e.g., cash flows, discount rates) affect project outcomes, identifying risks and tolerances.
What steps are involved in capital budgeting decisions?
Gathering decision-relevant information, evaluating alternatives using financial metrics, and applying a structured decision-making framework.
