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 focus

GAAP is not mandatory

Question 4

What values are used in Capital Budgeting?

Answer 4

Capital Budgeting ONLY uses Present Value tables.

Capital Budgeting NEVER uses Fair Value.

Question 7

When is the Present Value of $1 table used?

Answer 7

For ONE payment ONE time.

Question 9

When is the Present Value of an Annuity Due used?

Answer 9

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

Question 11

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

Answer 11

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

Question 13

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

Answer 13

1 / (( 1+i )^n)

i = interest rate
n = number of periods

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 17

How is NPV used to calculate future benefit?

Answer 17

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 19

What is the rate of return on an investment called?

Answer 19

The Discount Rate.

Question 21

What does the Discount Rate represent?

Answer 21

The rate of return on an investment used.

It represents the minimum rate of return required.

Question 23

What are the strengths of the Net Present Value system?

Answer 23

Uses the Time Value of Money

Uses all cash flows- not just the cash flows to arrive at Payback

Takes risks into consideration

Question 25

What are the weaknesses of the Net Present Value system?

Answer 25

Not as simple as the Accounting Rate of Return.

Question 27

How do Salvage Value and Depreciation affect Net Present Value?

Answer 27

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 29

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

Answer 29

The minimum rate of return is used.

Question 31

What is the Internal Rate of Return (IRR)?

Answer 31

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 33

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

Answer 33

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

Question 35

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

Answer 35

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

Rate of return for NPV is the minimum rate.

Question 37

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

Answer 37

Strengths: Uses Time Value of Money- Cash Flow emphasis

Weakness: Uneven cash flows lead to varied IRR

Question 39

When is NPV on an Investment positive?

Answer 39

When the benefits are greater than the costs.

IRR is greater than the Discount Rate

Question 41

When is NPV on an Investment Negative?

Answer 41

When Costs are greater than Benefits

IRR is less than the Discount Rate

Question 43

When is NPV Zero?

Answer 43

When benefits equal the Costs

IRR = Discount Rate

Question 44

What is the Payback Method? How is it calculated?

Answer 44

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 46

What are the strengths of the Payback Method?

Answer 46

Takes risk into consideration

2 year payback is less risky than a 5 year payback

Question 47

What are the weaknesses of the payback method?

Answer 47

Ignores the Time Value of Money

Exception: Discount payback method

Ignores cash flow after the initial investment is paid back

Question 48

What is the Accounting Rate of Return?

Answer 48

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 49

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

Answer 49

Simple to use

People understand easily

Question 50

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

Answer 50

Can be skewed based on Depreciation method that is used.

Ignores the Time Value of Money.

Question 51

What is an Expected Return?

Answer 51

An approximate rate of return on assets.