Capital Budgeting

Question 1

Discounted payback periord

Answer 1

Time value of money by discounting (lower value) results. If discounted numbers are accepted then payback method is accepted.

II. It is useful in evaluating the liquidity of a project. (all do)

I. It uses expected cash flows. (all do)

Does not measure total project profitability (it stops at break even)

Question 2

Accounting Rate of Return

Answer 2

ARR = Average annual incremental income/Initial (or Average) investment.

The accounting rate of return measures the expected annual incremental accounting income from a project as a percent of the initial (or average) investment in the project. Since it uses accounting income, it takes into account depreciation expense in computing the annual incremental income.

Entire Life of project
Does not consider Time value of money
Always deduct depreciation from net income

Question 3

Phillips Company is considering the acquisition of a new machine that would cost $66,000, has an expected life of 6 years, and an expected salvage value of $16,000. The company expects the machine to provide annual incremental income before taxes of $7,200. Phillips has a tax rate of 30%. If Phillips uses average values in its calculations, which one of the following will be the average accounting rate of return on the machine?

Answer 3

12.29 (Think Average)

Question 4

Net Present Value

Answer 4

NPV = Present value of cash inflows - Present value of cash outflows

Think Cash Flows
Compounding of results
Discount rate is determined in advance
Calculate pv of salvage value

Question 5

Internal Rate of Return

Answer 5

The IRR is the rate that equates the present value of net cash inflows with a project’s investment cost. Depreciation expense is not a cash flow and does not affect cash flows when income taxes are ignored; it should be excluded. The residual value of an asset at the end of a project is a cash flow, is discounted, and affects the present value of net cash inflows; it should be included

The discount rate at which the net present value of the project equals zero

Also called time-adjusted rate of return

All Cash flows immediately re-invvested (like NPV)

IRR and Accounting rate of return consider salvage value (IRR consider PV of salvage value, just like NPV method)

Question 6

Profitability Index Approach

Answer 6

The profitability index computes the expected return for each dollar invested. It is computed as: Net Present Value/Project Cost.

The profitability index (PI) method of capital project evaluation should be the method used in comparing capital projects when capital rationing needs to be considered. The profitability index method (also called the cost/benefit ratio) is primarily intended for use in ranking projects. It does so by taking into account both the present value and the cost of each project.