Capital Budgeting

Question 1

What are the approaches for evaluating capital budgeting opportunities?

Answer 1

Discounted Pay back period.
Payback period.
Profitability index
accounting rate of return
net present value
internal rate of return

Question 2

Payback period method formula

Answer 2

Payback = investment cost/annual increase in cash (or cash savings)
To determine how long it will take to recover (payback) the cost of the investment in the project.
Useful in evaluating the liquidity of a project.

Question 3

Capital budgeting

Answer 3

Concerned with capital investments that have prospects for long-term benefits

Question 4

Profitability index

Answer 4

Intended to rank capital budgeting projects in terms of desirability. concerned with the relative economic ranking of projects

Question 5

Net present value approach

Answer 5

Used for evaluating capital budgeting opportunities

Question 6

Discounted payback period approach

Answer 6

Takes the Time Value of Money into account. Used primarily to decide whether to accept or reject a project based on the economic feasibility of the project

Question 7

Discounted payback period

Answer 7

determines the number of periods required for the discounted cash inflows of a project to equal its discounted cash outflows

Question 8

Discounted payback period advantages

Answer 8

Uses time value of money
Useful in evaluating liquidity of a project.
Uses expected cash flows.

Question 9

Accounting rate of return

Answer 9

Measures the expected annual incremental accounting income from a project as a percent of the initial investment in the project.
Since it uses accounting income it takes into account depreciation expense in computing the annual incremental income.

Question 10

Accounting rate of return considers…

Answer 10

The entire life of the project.
Assumes that incremental net income is the same each year, including by using an average.
Compares that with established minimum rate required.

Question 11

How do you calc accounting rate of return?

Answer 11

ARR = (average annual incremental revenue - avg annual incremental expenses) / initial (or average) investment

Question 12

What are the disadvantages of the ARR approach?

Answer 12

Ignores TVM.

Uses accrual accounting values, not cash flows

Question 13

Advantages of ARR?

Answer 13

Consistent with FS values.

Considers entire life and results of a project

Question 14

ARR is also referred to as…

Answer 14

simple rate of return

Question 15

Net present value

Answer 15

PV of future cash inflows less the PV of the current costs of the machine. NOT NET INCOME

Question 16

What do you do with depreciation in net cash flow problems

Answer 16

multiple it by the tax rate and add to the cash inflow. It increases cash flow by reducing income taxes. It is the tax savings from the deductibility of the depreciation for tax purposes.

Question 17

What happens with the proceeds from the sale of an old asset?

Answer 17

increase the net PV of the replacement alternative

Question 18

What does the NPV approach and IRR approach assume about cash inflows?

Answer 18

That new cash inflows or savings will be immediately reinvested at the hurdle rate of return.

Question 19

How is the internal rate of return calculated?

Answer 19

By determining the rate or return implicit in the project.

Question 20

The discount rate or hurdle rate or return must be determined in advance when using which method?

Answer 20

NPV

Question 21

What is the internal rate of return?

Answer 21

A time-adjusted rate of return from an investment. (also called time adjusted rate or return) IT evaluates a project by determining the discount rate that equates the PV of a projects future cash inflows with the PV of the projects cash outflows. The discount rate at which the NPV of the project equals 0

Question 22

What is compared to the IRR to evaluate whether to make an investment?

Answer 22

the weighted average cost of capital

Question 23

How do you calc the IRR?

Answer 23

PV of inflows using IRR = PV of outflows using IRR.

Intial cost of the project / the annual savings of the project