Capital Budgeting

Question 1

What is Capital Budgeting? How is it used?

Answer 1

Managerial Accounting technique used to evaluate different investment options. Helps management make decisions. Uses both accounting and non-accounting information. Internal focusGAAP is not mandatory

Question 2

What values are used in Capital Budgeting?

Answer 2

Capital Budgeting ONLY uses Present Value tables. Capital Budgeting NEVER uses Fair Value.

Question 3

When is the Present Value of $1 table used?

Answer 3

For ONE payment ONE time. Value NOW of $ to be rcvd in FUTURE.

Question 4

When is the Present Value of an Annuity Due used?

Answer 4

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

Question 5

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

Answer 5

Multiple payments over time where payments are made at the END of the period.Think A for Arrears.

Question 6

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

Answer 6

FVCF / (( 1+i )^n) WHERE i : interest rate & n : number of periods

Question 7

How may bases for expressing & calculating Interest are there?

Answer 7

There are 6: 1)Stated Interest Rate 2)Simple Interest 3)Compound Interest 4)Effective Interest Rate 5)Annual percentage Rate 6)Effective annual percentage rate

Question 8

What is stated Interest Rate?

Answer 8

Annual Rate of Interest is the coupon or stated rate of Interest. Stated Rate of Interest ignores compounding.

Question 9

What is simple interest?

Answer 9

Simple Interest = Interest compounded on original pricipal only, no compounding in interest calculation & no interest paid on interest.

Example: 2 yr, $2,000 note @ 6% int. pd @ end.

Simple Interest = $2,000 x .06 x 2yrs = 240

Question 10

What is compounding Interest?

Answer 10

Compound Interest pays interest on principal PLUS unpaid accumulated interest.

Example: 2 yr note for $2,000 @ 6%.

Yr 1: $2,000 x .06 x 1 = 120.00

Yr 2: $2,120 x .06 x 1 = 127.20

Question 11

What is Effective Interest?

Answer 11

Effective Interest is the annual interest rate implicit in the relationship between net proceeds of a borrowing and the dollar cost of that borrowing.

Net Cost of Borrowing / Net Proceeds

due to (disc. int. deducted ahead or comp. bal/ required)

Example: 2yr, $2,000 @ 6%.

1st: $2,000 x .06 x 2 = $240
2nd: $2,000 - $240 = $1,760
3rd: ($240/$1,760)/2yrs = 6.82% effective int.

Question 12

What is Annual Percentage Rate (APR)?

Answer 12

Annualized Effective Rate w/out compounding on borrowing for a fraction of a year.

APR = Interest (cost) / (Principal x Time Factor of Yr.)

*Note: APR is the legally required basis for interest rate disclosure in the US.

Question 13

What is Effective Annual Percentage Rate (EAPR)?

Answer 13

Annual percentage rate WITH compounding on borrowing for a fraction of a year. Also called Annual Percentage Yield (APY).

Formula: EAPR = (1 + i/p)^p -1

where i = annual rate & p = periods in year

Example: (1+.06/4)^4 -1 = (1.015^4) -1

(1.015^4) -1 = 1.06136 - 1 = 06.136%

Question 14

What is the formula for computing annual rate of interest when not taking credit terms? ie: “2/10,net 30”

Answer 14

If the example was 2/10, net 30, then

APR = (Interest / Principal) x (1 / (20/360)

note 20 comes from the difference in 30 days to pay the invoice minus the 10 days available for the discount and the 360 is the # of days in a year

Question 15

What is Net Present Value (NPV)?

Answer 15

A preferred method of evaluating profitability. One of two methods that use the Time Value of Money : PV of Future Cash Flows - Investment

Question 16

How is NPV used to calculate future benefit?

Answer 16

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)

Question 17

What is the rate of return on an investment called?

Answer 17

The Discount Rate.

Question 18

What does the Discount Rate represent?

Answer 18

The rate of return on an investment used. It represents the minimum rate of return required.

Question 19

What are the strengths of the Net Present Value system?

Answer 19

Uses the Time Value of Money Uses all cash flows- not just the cash flows to arrive at Payback Takes risks into consideration

Question 20

What are the weaknesses of the Net Present Value system?

Answer 20

Not as simple as the Accounting Rate of Return.

Question 21

How do Salvage Value and Depreciation affect Net Present Value?

Answer 21

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.

Question 22

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

Answer 22

The minimum rate of return is used.

Question 23

What is the Internal Rate of Return (IRR)?

Answer 23

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

Question 24

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

Answer 24

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

Question 25

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

Answer 25

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

Question 26

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

Answer 26

Strengths: Uses Time Value of Money- Cash Flow emphasis Weakness: Uneven cash flows lead to varied IRR

Question 27

When is NPV on an Investment positive?

Answer 27

When the benefits are greater than the costs. IRR is greater than the Discount Rate

Question 28

When is NPV on an Investment Negative?

Answer 28

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

Question 29

When is NPV Zero?

Answer 29

When benefits equal the Costs IRR : Discount Rate

Question 30

What is the Payback Method? How is it calculated?

Answer 30

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.

Question 31

What are the strengths of the Payback Method?

Answer 31

Takes risk into consideration 2 year payback is less risky than a 5 year payback

Question 32

What are the weaknesses of the payback method?

Answer 32

Ignores the Time Value of Money Exception: Discount payback method Ignores cash flow after the initial investment is paid back

Question 33

What is the Accounting Rate of Return?

Answer 33

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.

Question 34

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

Answer 34

Simple to use People understand easily

Question 35

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

Answer 35

Can be skewed based on Depreciation method that is used. Ignores the Time Value of Money.

Question 36

What is an Expected Return?

Answer 36

An approximate rate of return on assets.

Question 37

What is the capital budgeting model that is generally considered the best model for long range decision making?

Answer 37

The Discounted Cash Flow Model. Discounted Cash Flow model includes: NPV, IRR, & profitability index.