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BEC > Capital Budgeting > Flashcards

Capital Budgeting Flashcards

1
Q

What is Capital Budgeting?

How is it used?

A

Managerial Acctg technique used to evaluate different investment options

Helps mgmt make decisions

Uses both Acctg + Non-acctg info

Internal focus

GAAP is not mandatory

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2
Q

What values are used in Capital Budgeting?

A

ONLY uses PV tables

NEVER uses Fair Value

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3
Q

When is the PV of $1 table used?

A

For ONE payment- ONE time.

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4
Q

When is the PV of an Annuity Due used?

A

Multiple payments made over time

Payments are made at the START of the period

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5
Q

When is the PV of an Ordinary Annuity of $1

(PVOA) used?

A

Multiple payments over time

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

Preferred method of evaluating profitability

One of two methods that use the Time Value of Money

PV of Future Cash Flows

- Investment

NPV

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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 > benefits (bad investment)

If NPV is Positive, Cost < benefit (good investment)

If NPV = 0, Cost = Benefit (Mgmt 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 NPV 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 NPV includes tax considerations, 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 benefits > costs.

IRR > Discount Rate

20
Q

When is NPV on an Investment Negative?

A

When Costs > Benefits

IRR < Discount Rate

21
Q

When is NPV Zero?

A

When benefits = 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 = Payback Method

Annual Cash Inflow

Compare to a targeted timeframe

If payback is shorter than target, good investment.

If payback takes longer, bad investment.

23
Q

What are the strengths of the Payback Method?

A

Takes risk into consideration

2 yr payback is less risky than a 5 yr 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

Approximate rate of return on assets

ARR = Net Income

Avg 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

Ignores the Time Value of Money

28
Q

What is an Expected Return?

A

An approximate rate of return on assets.

BEC (9 decks)

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