Capital budgeting Flashcards
What is Capital budgeting?
Process of decision making with respect to investments fixed assets.
Should a project be accepted or rejected
What are Capital Budgeting decision criteria?
Payback Period
Net Present Value
Profitiability Index
Internal Rate of return
What is the Payback Period?
Number of years needed to recover the initial cash outlay of a capital budgeting project
What are the Payback Period advantages / disadvantages?
Benefits:
Uses cashflow rather than accounting profits
Easy to compute and understand
Useful for firms that have capital constraints
Drawbacks:
Ignores the time value of money and
does not consider cash flows beyond the payback period
What is the discounted Payback Period?
Similar to traditional payback period -> uses discounted free cash flows
What is the NPV?
Equal to the present value of all future free cash flows less the investment’s initial outlay. It measures the net value of a project in todays dollars.
When subtracting sum of NPV with initial outlay and NPV > 0 -> Project is feasible
What are NPV tradeoffs?
Benefits:
Considers cash flow, not profit
Considers all cash flows
Recognizes time value of money
Drawbacks:
Requires long term forecast
Is considered to be the most theoretically correct criterion for evaluating capital bdgeting projects
What is the Profitability Index (PI)?
Is the ratio of the present value of the future free cash flows (FCF) to the initial outlay. it yields the same accept/reject decision as NPV
PI = PV of FCF / Initial Outlay
If PI > 1 -> Accept
If PI < 1 -> Reject
What is the Internal rate of Return?
Is the discount rate that equates the present value of a projects future net cash flows with the projects initial cash outlay
If IRR > Required Rate of return
If IRR < Required Rate of Return
What is the Correlation of NPV and IRR?
If NPV is positive, IRR will be greater than the required rate of return
If NPV is negative, IRR will be less thn reuquired rate of return
If NPV = 0, IRR is the required rate of return
What is Capital Rationing?
Refers to the situation where there is a limit of on the dollar size of the capital budget
Reasons:
temporarily adverse conditions in the market
Shortage of qualified personnel to direct new projects
other factors such as not willing to take on excess debt to finance new projects
What are Problem while compairing Projects?
Size Disparity
Time Disparity
Unequal Life
How do solve Size Disparity?
Use NPV
How to solve Time Disparity?
Use NPV
How to solve Unequal Lives Problem?
Compare Equivalent Annual Annuity (EAA)
= NPV / annual annuity factor
