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CPA - BEC > Capital Budgeting > Flashcards

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.

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.

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

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

20
Q

When is NPV on an Investment Negative?

A

When Costs are greater than Benefits IRR is less than the Discount Rate

21
Q

When is NPV Zero?

A

When benefits equal the Costs IRR : Discount Rate

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.

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

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

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.

26
Q

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

A

Simple to use People understand easily

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.

28
Q

What is an Expected Return?

A

An approximate rate of return on assets.

29
Q

Three Common Methods of Computing the Cost of Retained Earnings

A

Capital Asset Pricing Model (CAPM) Discounted Cash Flow (DCF) Bond Yield Plus Risk Premium (BYRP)

30
Q

Formula for Cost of Retained Earnings (CAPM)

A

Risk-free rate + [Beta x (Market return - Risk-free rate)]

31
Q

Discounted Cash Flow (DCF) Formula

A

Future Dividend (Todays dividend x 1 + growth rate) divided by Current Market Price plus growth rate. D1/P0 + G (Dividend Yield + Growth) - usually only for companies that give dividends frequently.

32
Q

Formula to determine Future Dividend

A

Today’s dividend x (1 + growth rate)

33
Q

Bond Yield Plus Risk Premium (BYRP) Formula

A

Pretax cost of long-term debt + Market risk premium (Reward for buying riskier Common Equity) pg 28

34
Q

Return on Investment Formula

A

Income/Investment Capital (Debt + Equity) Net Income / Average Assets or Average PP&E + Avg. WC. Higher the percentage return the better

CPA - BEC (16 decks)

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