Capital Budgeting Flashcards
Managerial Accounting technique used to evaluate different investment options
Helps management make decisions
Uses both accounting and non-accounting information
Internal focus
GAAP is not mandatory
Capital Budgeting
Capital Budgeting ONLY uses Present Value tables.
Capital Budgeting NEVER uses Fair Value.
Capital Budgeting
For ONE payment- ONE time.
Capital Budgeting
Multiple payments made over time- where the payments are made at the START of the period.
Capital Budgeting
Multiple payments over time- where payments are made at the END of the period.
Think A for Arrears.
Capital Budgeting
1 / (( 1+i )^n)
i : interest rate
n : number of periods
Capital Budgeting
A preferred method of evaluating profitability.
One of two methods that use the Time Value of Money
: PV of Future Cash Flows - Investment
Capital Budgeting
NPV : PV Future Cash Flows - Investment
If NPV is Negative- Cost is greater than benefits (bad investment)
If NPV is Positive- Cost is less than benefit (good investment)
If NPV : 0- Cost : Benefit (Management is indifferent)
Capital Budgeting
The Discount Rate.
Capital Budgeting
The rate of return on an investment used.
It represents the minimum rate of return required.
Capital Budgeting
Uses the Time Value of Money
Uses all cash flows- not just the cash flows to arrive at Payback
Takes risks into consideration
Capital Budgeting
Not as simple as the Accounting Rate of Return.
Capital Budgeting
NPV includes Salvage Value because it is a future cash inflow.
NPV does NOT include depreciation because it is non-cash.
Exception - If a CPA Exam question says to include tax considerations- then you have to include depreciation because of income tax savings generated by depreciation.
Capital Budgeting
The minimum rate of return is used.
Capital Budgeting
It calculates a project’s actual rate of return through the project’s expected cash flows.
IRR is the rate of return required for PV of future cash flows to EQUAL the investment.
Investment / After Tax Annual Cash Inflow : PV Factor
Capital Budgeting
Cash flows are re-invested at the rate of return earned by the original investment.
Capital Budgeting
Rate of return for IRR is the rate earned by the investment.
Rate of return for NPV is the minimum rate.
Capital Budgeting
Strengths: Uses Time Value of Money- Cash Flow emphasis
Weakness: Uneven cash flows lead to varied IRR
Capital Budgeting
When the benefits are greater than the costs.
IRR is greater than the Discount Rate
Capital Budgeting
When Costs are greater than Benefits
IRR is less than the Discount Rate
Capital Budgeting
When benefits equal the Costs
IRR : Discount Rate
Capital Budgeting
It measures an investment in terms of how long it takes to recoup the initial investment via Annual Cash Inflow
Investment / Annual Cash Inflow : Payback Method
Compare to a targeted timeframe; if payback is shorter than target- it’s a good investment. If payback is longer than target- it’s a bad investment.
Capital Budgeting
Takes risk into consideration
2 year payback is less risky than a 5 year payback
Capital Budgeting
Ignores the Time Value of Money
Exception: Discount payback method
Ignores cash flow after the initial investment is paid back
Capital Budgeting
An approximate rate of return on assets
ARR : Net Income / Average Investment
Compare to a targeted return rate; if ARR greater than target- good investment. If ARR less than target- bad investment.
Capital Budgeting
Simple to use
People understand easily
Capital Budgeting
Can be skewed based on Depreciation method that is used.
Ignores the Time Value of Money.
Capital Budgeting
An approximate rate of return on assets.
Capital Budgeting
