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Capital Budgeting Flashcards

1
Q

What is Capital Budgeting? How is it used?

A

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

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2
Q

What values are used in Capital Budgeting?

A

Capital Budgeting ONLY uses Present Value tables.

Capital Budgeting NEVER uses Fair Value.

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3
Q

When is the Present Value of $1 table used?

A

For ONE payment- ONE time.

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4
Q

When is the Present Value of an Annuity Due used?

A

Multiple payments made over time- where the payments are made at the START of the period.

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5
Q

When is the Present Value of an Ordinary Annuity of $1 (PVOA) used?

A

Multiple payments over time- where payments are made at the END of the period.

Think A for Arrears.

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6
Q

What is the calculation for the Present Value of $1?

A

1 / (( 1+i )^n)

i : interest rate
n : number of periods

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7
Q

What is Net Present Value (NPV)?

A

A preferred method of evaluating profitability.

One of two methods that use the Time Value of Money
: PV of Future Cash Flows - Investment

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8
Q

How is NPV used to calculate future benefit?

A

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)

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9
Q

What is the rate of return on an investment called?

A

The Discount Rate.

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10
Q

What does the Discount Rate represent?

A

The rate of return on an investment used.

It represents the minimum rate of return required.

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11
Q

What are the strengths of the Net Present Value system?

A

Uses the Time Value of Money

Uses all cash flows- not just the cash flows to arrive at Payback

Takes risks into consideration

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12
Q

What are the weaknesses of the Net Present Value system?

A

Not as simple as the Accounting Rate of Return.

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13
Q

How do Salvage Value and Depreciation affect Net Present Value?

A

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.

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14
Q

If multiple potential rates of return are available- which is used to calculate Net Present Value?

A

The minimum rate of return is used.

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15
Q

What is the Internal Rate of Return (IRR)?

A

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

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16
Q

Which rate of return is used to re-invest cash flows for Internal Rate of Return?

A

Cash flows are re-invested at the rate of return earned by the original investment.

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17
Q

How does the rate used for Internal Rate of Return (IRR) compare to that used for Net Present Value (NPV)?

A

Rate of return for IRR is the rate earned by the investment.

Rate of return for NPV is the minimum rate.

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18
Q

What are the strengths and weaknesses of the Internal Rate of Return system?

A

Strengths: Uses Time Value of Money- Cash Flow emphasis

Weakness: Uneven cash flows lead to varied IRR

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19
Q

When is NPV on an Investment positive?

A

When the benefits are greater than the costs.

IRR is greater than the Discount Rate

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20
Q

When is NPV on an Investment Negative?

A

When Costs are greater than Benefits

IRR is less than the Discount Rate

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21
Q

When is NPV Zero?

A

When benefits equal the Costs

IRR : Discount Rate

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22
Q

What is the Payback Method? How is it calculated?

A

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.

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23
Q

What are the strengths of the Payback Method?

A

Takes risk into consideration

2 year payback is less risky than a 5 year payback

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24
Q

What are the weaknesses of the payback method?

A

Ignores the Time Value of Money

Exception: Discount payback method

Ignores cash flow after the initial investment is paid back

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25
Q

What is the Accounting Rate of Return?

A

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.

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26
Q

What are the strengths of the Accounting Rate of Return (ARR)?

A

Simple to use

People understand easily

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27
Q

What are the weaknesses of the Accounting Rate of Return (ARR)?

A

Can be skewed based on Depreciation method that is used.

Ignores the Time Value of Money.

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28
Q

What is an Expected Return?

A

An approximate rate of return on assets.

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29
Q

What is Capital Budgeting? How is it used?

A

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

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

What values are used in Capital Budgeting?

A

Capital Budgeting ONLY uses Present Value tables.

Capital Budgeting NEVER uses Fair Value.

31
Q

When is the Present Value of $1 table used?

A

For ONE payment- ONE time.

32
Q

When is the Present Value of an Annuity Due used?

A

Multiple payments made over time- where the payments are made at the START of the period.

33
Q

When is the Present Value of an Ordinary Annuity of $1 (PVOA) used?

A

Multiple payments over time- where payments are made at the END of the period.

Think A for Arrears.

34
Q

What is the calculation for the Present Value of $1?

A

1 / (( 1+i )^n)

i : interest rate
n : number of periods

35
Q

What is Net Present Value (NPV)?

A

A preferred method of evaluating profitability.

One of two methods that use the Time Value of Money
: PV of Future Cash Flows - Investment

36
Q

How is NPV used to calculate future benefit?

A

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)

37
Q

What is the rate of return on an investment called?

A

The Discount Rate.

38
Q

What does the Discount Rate represent?

A

The rate of return on an investment used.

It represents the minimum rate of return required.

39
Q

What are the strengths of the Net Present Value system?

A

Uses the Time Value of Money

Uses all cash flows- not just the cash flows to arrive at Payback

Takes risks into consideration

40
Q

What are the weaknesses of the Net Present Value system?

A

Not as simple as the Accounting Rate of Return.

41
Q

How do Salvage Value and Depreciation affect Net Present Value?

A

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.

42
Q

If multiple potential rates of return are available- which is used to calculate Net Present Value?

A

The minimum rate of return is used.

43
Q

What is the Internal Rate of Return (IRR)?

A

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

44
Q

Which rate of return is used to re-invest cash flows for Internal Rate of Return?

A

Cash flows are re-invested at the rate of return earned by the original investment.

45
Q

How does the rate used for Internal Rate of Return (IRR) compare to that used for Net Present Value (NPV)?

A

Rate of return for IRR is the rate earned by the investment.

Rate of return for NPV is the minimum rate.

46
Q

What are the strengths and weaknesses of the Internal Rate of Return system?

A

Strengths: Uses Time Value of Money- Cash Flow emphasis

Weakness: Uneven cash flows lead to varied IRR

47
Q

When is NPV on an Investment positive?

A

When the benefits are greater than the costs.

IRR is greater than the Discount Rate

48
Q

When is NPV on an Investment Negative?

A

When Costs are greater than Benefits

IRR is less than the Discount Rate

49
Q

When is NPV Zero?

A

When benefits equal the Costs

IRR : Discount Rate

50
Q

What is the Payback Method? How is it calculated?

A

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.

51
Q

What are the strengths of the Payback Method?

A

Takes risk into consideration

2 year payback is less risky than a 5 year payback

52
Q

What are the weaknesses of the payback method?

A

Ignores the Time Value of Money

Exception: Discount payback method

Ignores cash flow after the initial investment is paid back

53
Q

What is the Accounting Rate of Return?

A

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.

54
Q

What are the strengths of the Accounting Rate of Return (ARR)?

A

Simple to use

People understand easily

55
Q

What are the weaknesses of the Accounting Rate of Return (ARR)?

A

Can be skewed based on Depreciation method that is used.

Ignores the Time Value of Money.

56
Q

What is an Expected Return?

A

An approximate rate of return on assets.

57
Q

M

What is the primary duty of the board of directors?

A

To monitor management behavior.

58
Q

M

What is the responsibility of the Nominating or Corporate Governance Committee of the board of directors?

A

Oversees the board

Responsible for hiring new CEO

59
Q

M

What is the responsibility of the audit committee of the board of directors?

A

The audit committee appoints and oversees the external auditor.

60
Q

M

What is the duty of the compensation committee of the board of directors?

A

The compensation committee handles the CEO’s compensation package.

61
Q

M

What does the NYSE and NASDAQ require of the board of directors?

A

They require the board to be independent.

62
Q

M

What is the main goal in an executive compensation package?

A

The package should ensure that the goals of management should match those of the shareholders.

63
Q

M

How can an executive compensation package ensure that goals of management align with those of shareholders?

A

Executive compensation should create an incentive for management to govern in a shareholder-friendly way that doesn’t sacrifice the long-term success of the enterprise for short-term gain.

64
Q

M

Which influences help mold the direction that management takes?

A

They range from internal (Board of Directors- Audit Committee- Internal Control) to external (Creditors- SEC- IRS)

These influences should not be tainted by undue influence from management or have financial ties to management such as compensation-related duties

65
Q

M

What is shirking?

A

When management doesn’t act in the best interest of shareholders.

It can be alleviated by tying compensation to stock performance or company profit.

66
Q

M

What requirements are imposed on a public company under Sarbanes-Oxley?

A

Management must submit a report on the effectiveness of Internal Control in the 10K.

Management must disclose significant Internal Control deficiencies.

CEO/CFO must certify that the financial statements comply with securities laws and fairly present the financial condition of the company.

67
Q

M

What characteristics are promoted by the COSO framework on Internal Control?

A

Reliable financial reporting

Effective and efficient operations

Compliance

68
Q

M

What are the elements of the control environment?

A 
Integrity & Ethics
Competence
The Board of Directors & Audit Committee
Management's Operating Style
Organizational Structure
Authority & Roles of Responsibilities
HR Policies
69
Q

M

What are control activities?

A

A component of Internal Control that includes actions being taken to promote the control environment.

70
Q

M

What are the basic elements of Internal Control?

A 
Control Environment
Risk Assessment
Control Activities
Information and Communication
Monitoring
71
Q

M

What is the significance of the Information and Communication aspect of Internal Control?

A

Management must have access to relevant and timely information to make good decisions.

72
Q

M

How does Monitoring affect Internal Control?

A

Internal Control activities must be constantly monitored and evaluated for effectiveness.

73
Q

M

What activities does the COSO framework for enterprise risk management include?

A 
Identifies Risk Factors
Promotes Risk Response Decisions
Compares Management Risk vs. Shareholder Goals
Aids in evaluating opportunities
Promotes Quicker Capital movement

Does NOT eliminate all risk

74
Q

M

What are possible responses to risk under the COSO framework for enterprise risk management?

A

Avoid or Reduce

Share or Accept

bec (10 decks)

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