Capital Budgeting Flashcards
What is Capital Budgeting?
the process of decision making with respect to investments made in fixed assets
What is a major assumption of capital budgeting?
all cash flows associated with a project are known
What is one of the most difficult aspects of capital budgeting?
Finding new profitable projects within competitive markets — a firm must have a systematic strategy for identifying these projects because without the flow of new projects and ideas, the firm cannot grow or survive in the long-run
4 Capital Budgeting Assumptions
- The cash flows for a project
- An appropriate discount rate
- The required rate of return (RORR)
- The cost of capital
8 Capital Budgeting Techniques
- Simple Rate of Return / Accounting rate of return
- Payback period
- True payback period
- Discounted payback period
- Net present value (NPV)
- Profitability index or benefit-cost ratio
- Internal Rate of Return (IRR)
- Modified Rate of Return (MIRR)
What do the first 3 Capital budgeting techniques not incorporate?
Time value of money calculations
Simple Rate of Return (SRR)
the incremental amount of net operating income expected from a project, divided by the investment amount (also known as accounting rate of return)
What are the limitations to SRR?
It does not consider the time value of money and it assumes constant incremental revenues/expenses over a projects lifespan
Payback Period (PP)
The average number of years it takes to recapture a projects initial outlay.
the result is compared to the firm’s maximum payback period benchmark to decide whether to accept or reject the project
True Payback Period (TPP)
the number of years it takes to recapture a project’s initial outlay
Limitations to TPP
- Weighs all cash flows equally. Time value of money tells us this is not the case.
- All cash flows occurring after the payback period are ignored. Don’t investors desire more money as opposed to less?
- The choice of a firm’s maximum desired payback period is arbitrary.
Discounted Payback Period (DPP)
the number of years it takes to recapture a projects initial outlay from the discounted cash flows
determined using the same equation as the true payback period, except the cash flows are first discounted before implementing the equation
Net Present Value (NPV)
The present value of the annual cash flows less then the initial outlay. A measurement of a project’s net value in today’s dollars.
What does NPV inform management?
How much value is created or destroyed if a project is accepted
Is NPV inversely related to discount rate?
Yes
NPV Decision criteria
- NPV greater than or equal to zero = ACCEPT (return exceeds RROR)
- NPV less than or equal to zero = REJECT (return below RROR)
- NPV equal to zero = ACCEPT (return equal to RROR)
Advantages of NPV
- Uses cash flows rather than profits; sensitive to timing of projects benefits
- Recognizing time value of money allows benefits and costs to be compared
- Accepting projects with a positive NPV will increase the value of the firm
Disadvantage of NPV
need for detailed, long-term forecasts
Profitability Index (PI)
A ratio of the present value of a projects future cash flows to its initial outlay (also known as benefits-cost ratio)
PI Decision Criteria
- PI greater than or equal to zero = ACCEPT (exceeds RROR)
- PI less than or equal to zero = REJECT (below RROR)
- PI equal to one = ACCEPT (equal to RROR)
Internal Rate of Return (IRR)
The discount rate that equates the present value of a projects inflows with its outflows, it determines the ROR earned by the project
IRR decision criteria
- IRR greater than or equal to firms required ROR —> ACCEPT
- ITR less than firms required ROR —> REJECT
IRR - Disadvantages
- IRR assumes reinvested cash flows over the life of the project earn the IRR
- NPV assumes reinvested cash flows earn the RROR, which can be returned as dividends to the shareholders or reinvested in a new project. In both instances, the RROR is demanded.
- When the cash flow stream has more than one sign reversal, the possibility of multiple IRRs exists and the normal interpretation of the IRR loses its meaning
Modified Internal Rate of Return (MIRR)
The discount rate that equates the present value of a projects future cash flows with the terminal value of the cash flows
