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L1 36 Capital Budgeting > Capital Budgeting > Flashcards

Capital Budgeting Flashcards

0
Q

Capital Projects on the balance sheet

A

Long term assets

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1
Q

Capital projects

A

Projects>1 year

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2
Q

Budgeting

A

The allocation of funds

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3
Q

Capital budgeting

A

Funds to long range projects or investments

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4
Q

Real capital investments describe a company better than working capital or capital structure

A

Working capital and capital structure are intangible

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5
Q

Working capital and capital structure tend to be similar for many corporations

A

???

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6
Q

Capital budget decision making is important

A

They’re long term so mistakes are costly.

The principles of capital budgeting apply to investments in working capital, leasing, mergers and acquisitions, bond refunding

Capital budgeting valuation principles are similar to security analysis principles and portfolio management principles

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7
Q

Working capital

A

Current assets - current liabilities

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8
Q

Capital structures

A

Debt:equity mix for long term financing a companies business

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9
Q

Leasing

A

???

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10
Q

Mergers and acquisitions

A

???

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11
Q

Bond refunding

A

???

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12
Q

Capital budgeting principles or assumptions

A

Decisions are based on CF’s, not NI

Intangibles are ignored

Timing of CF’s is crucial

CF’s are based on opportunity costs

CF’s are analyzed on an after tax basis

Financing costs are ignored

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13
Q

An analysts interest in capital budgeting valuation

A

The capital budgeting focus of maximizing shareholder value

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14
Q

The cash flows that go into the capital budgeting model

A

???

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15
Q

Extensions of the basic capital budgeting model

A

???

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16
Q

The most critical investments for many corporations

A

Investments in long-term assets

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17
Q

Analyzing individual proposals

A

Gather information to forecast cash flows then evaluate profitability

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18
Q

Planning the capital budget

A

Must fit with companies strategies and must be timely

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19
Q

Post-auditing and monitoring

A

Compare actual results to planned or predicted results

Explain differences

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20
Q

Various categories of capital projects

A

Replacement

Expansion

New products and services

Regulatory

Safety and environmental

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21
Q

Replacement projects

A

Easy to budget. Just make the replacement to maintain business activities.

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22
Q

Expansion projects

A

Increasing the size of the business

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23
Q

New products and services projects

A

Complex. More people and uncertainty.

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24
Q

Regulatory, safety, environmental projects

A

Imposed by gov. Generate no revenue. Companies undertake to max own interests.

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25
Q

Incremental-after tax cash flows

A

???

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26
Q

Capital budgeting decision base

A

NPV

The PV of all after tax CF’s

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27
Q

Capital budgeting decision process ignores financing costs

A

The discount rate already captures the cost of debt and the cost of other capital

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28
Q

Net present value

A

Present value of all after-tax cash flows

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29
Q

r in NPV

A

The investments required rate of return

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30
Q

Investment outlays in NPV

A

Negative CF’s

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31
Q

IRR

A

Sums PV of all future CF’s to 0

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32
Q

Payback period

A

Periods till CF’s payback the investment

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33
Q

Discounted payback period

A

Periods til cumulative discounted CF’s payback the initial outlay (investment)

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34
Q

AAR

A

Average Accounting Rate of Return

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35
Q

Average accounting rate of return

A

Avg NI / Avg Book Value

Avg profit per resources basically?

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36
Q

Book value

A

Net excess amount of total assets or total liabilities

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37
Q

PI

A

Profitability Index

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38
Q

Profitability Index

A

The PV of a projects future CF’s / initial investment

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39
Q

PI will =

A

1+NPV/initial investment

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40
Q

Capital budgeting decision rule - invest

A

NPV>0 , IRR > r , PI > 1.0

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41
Q

NPV>0

A

Invest

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42
Q

IRR>r

A

Invest

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43
Q

PI>1.0

A

Invest

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44
Q

No decision rules for the payback period, discounted payback period, AAR

A

Not always sound measures

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45
Q

payback period, discounted payback period, AAR are not always sound measures

A

???

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46
Q

NPV profile

A

NPV graphed as a function of various discount rates

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47
Q

Mutually exclusive projects that are ranked differently by NPV and IRR

A

???

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48
Q

If mutually exclusive projects are ranked differently by NPV and IRR, then be economically sound

A

Choose The project with the higher NPV

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49
Q

Multiple IRR problem

A

???

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50
Q

No IRR Problem

A

???

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51
Q

Nonconventional cash flows

A

CF’s that change signs more than once during a projects life

52
Q

Projects with non-conventional cash flows cause this…

A

Multiple IRR problem or No IRR problem

53
Q

Why do non-conventional cash flows occur?

A

??

54
Q

The popularity of NPV as an evaluation method

A

Projects with a positive NPV theoretically increase the value of a company and it’s stock.

55
Q

Evaluation method.

A

??

56
Q

The capital budgeting process

A

??

57
Q

Typical capital budgeting steps

A

??

58
Q

Distinctive categories of capital projects

A

??

59
Q

Basic principles of capital budgeting

A

?

60
Q

Basic principles of CF estimation

A

?

61
Q

Mutually exclusive projects affect the evaluations and selection of capital projects

A

?

62
Q

Project sequencing

A

?

63
Q

Project sequencing affects the evaluations and selection of capital projects

A

?

64
Q

Capitol rationing

A

?

65
Q

Capital rationing affects the evaluations and selection of capital projects

A

?

66
Q

Methods to evaluate a single capital project

A

NPV

IRR

Payback Period

Discounted Payback Period

PI

67
Q

NPV interpretation

A

?

68
Q

IRR interpretation

A

?

69
Q

Payback period interpretation

A

?

70
Q

Discounted Payback Period interpretation

A

?

71
Q

PI interpretation

A

?

72
Q

NPVs role in evaluating independent projects

A

?

73
Q

IRR’s role in evaluating independent projects

A

?

74
Q

NPV’s role in evaluating mutually exclusive projects

A

?

75
Q

IRR’s role in evaluating mutually exclusive projects

A

?

76
Q

Other projects

A

Pet or RD

77
Q

Economic income

A

Economic income does not subtract the cost of debt financing

Econ income is based on changes in the market value of the company - not book value

78
Q

Required rate of return or opportunity cost of funds or cost of capital

A

Required discount rate given a projects riskiness

79
Q

Important capital budgeting concepts that managers find useful

A

Sunk cost

Opportunity cost

Incremental cash flow

Externality

Conventional CF’s v. Nonconventional CF’s

80
Q

Sunk cost

A

Costs already incurred which cannot be changed. Sunk costs do not effect current and future CF’s

81
Q

Opportunity cost

A

What a resource is worth in its next best use

82
Q

Incremental cash flow

A

The CF that is realized because of a decision

83
Q

Externality

A

A positive or cannibalistic effect of the project on CF’s of other parts of the company.

84
Q

Conventional CF pattern

A

Initial outflow is followed by a series of inflows

85
Q

Nonconventional CF pattern

A

The initial CF is not followed by inflows only but also changes to the signs, + - + -

If CF’s change signs two or more times

86
Q

Project interactions that make incremental CF analysis challenging

A

Independent projects v. Mutually exclusive projects
Project sequencing
Unlimited funds v Capitol rationing

87
Q

Independent projects

A

CF’s are independent of each other

88
Q

Mutually exclusive projects

A

Projects compete directly with each other and only one can be chosen

89
Q

Project sequencing

A

Investing through projects in time especially if CF’s one project could budget a second project.

90
Q

Unlimited funds

A

A company can raise a project simply by paying the required rate of return

91
Q

Capital rationing

A

Company’s should ration capital especially when they have more profitable projects than funds in order to achieve max shareholder value.

92
Q

Economic logic behind NPV

A

?

93
Q

NPV strengths

A

?

94
Q

NPV weaknesses

A

?

95
Q

Economic logic behind IRR

A

?

96
Q

IRR strengths

A

?

97
Q

IRR weaknesses

A

?

98
Q

Independent projects decision rule

A

Accept any projects that increases shareholders wealth aka NPV > 1

99
Q

IRR definition

A

For a project with one investment outlay, made initially, the IRR is the discount rate that makes the PV of the future after-tax CF’s equal to the investment outlay.

100
Q

IRR Decision Rule

A

Determine the required rate of return for a project

If IRR > required rate of return accept

IRR<Req. Rate of return, reject

101
Q

The required rate of return for a project

A

Is usually the firms cost of capital

102
Q

The payback period

A

The number of years it takes to recover the cost of the initial investment

103
Q

The payback period is measure of liquidity that means

A

A shorter payback period is better, especially for firms with liquidity concerns

104
Q

Main payback period drawbacks

A

PBP don’t account the TVM or CF’s beyond PBP

105
Q

PBP don’t account the TVM or CF’s beyond PBP

A

Terminal or salvage value isn’t considered, useless as a measure of profitability

106
Q

PBP main benefit

A

Good measure of project liquidity

107
Q

PBP when annual CF’s are =

A

Project cost\annual CF

108
Q

Discounted payback period

A

A liquidity measure, not profitability

The number of years it takes a project to recover its initial investment in present value terms

109
Q

PI, NPV, IRR relationship

A

If PI>1 then NPV>0 and IRR>r, etc

110
Q

PI

A

The PV of a projects future CF’s \ initial cash outlay

111
Q

Another IRR def when outlays occur t=0 or future dates

A

The discount rate that makes the PV of all CF’s sum to 0

112
Q

Problems associated with NPV

A

?

113
Q

Problems associated with IRR

A

?

114
Q

NPV profile explained

A

?

115
Q

Relationship among an investments NPV, Company value, and Share Price

A

?

116
Q

What is payback based on?

A

CF’s

117
Q

PBP advantage

A

Very easy to calculate and to explain

118
Q

PBP has no decision rules

A

It isn’t economically sound

119
Q

Economically sound

A

??

120
Q

A project with negative NPV does not have a discounted payback period

A

Since -NPV indicates that the CF is not paid back

121
Q

How DPBP corrects PBP

A

Accounts for TVM and risk within discounted payback period.

122
Q

DPBP and PBP ignore CF’s after DPB or PB is reached

A

It’s possible a project has negative NPV but to have a +cumulative DCF in the middle of its life and this a reasonable discounted payback period

123
Q

AAR

A

Avg NI/ Avg book value

124
Q

AAR advantages

A

Easy to understand easy to calculate

125
Q

AAR disadvantages

A

Based on accounting numbers not CF’s

Doesn’t account TVM

Doesn’t distinguish what’s profitable or unprofitable

Callcd many different ways

126
Q

PI

A

PV projects future CF/ initial investment(outlay)

127
Q

PI v NPV regarding future CF and initial outlay

A

PI is the ratio

NPV is the difference

128
Q

PI indicates the value you are receiving in exchange for one unit of currency

A

Or benefit-to-cost ratio

L1 36 Capital Budgeting (8 decks)

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