Capital Budgeting Flashcards
Capital budgeting is the
planning process used to determine which of an organization’s long term investments are worth pursuing.
Capital budgeting, which is also called investment appraisal, is
the planning process used to determine whether an organization’s long-term investments, major capital, or expenditures are worth pursuing.
Major methods for capital budgeting include
Net present value, Internal rate of return, Payback period, Profitability index, Equivalent annuity and Real options analysis.
APT:
In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds, which holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient.
Modified Internal Rate of Return:
The modified internal rate of return (MIRR) is a financial measure of an investment’s attractiveness. It is used in capital budgeting to rank alternative investments of equal size. As the name implies, MIRR is a modification of the internal rate of return (IRR) and, as such, aims to resolve some problems with the IRR.
Capital budgeting, which is also called “investment appraisal,” is
the planning process used to determine which of an organization’s long-term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing.
Many formal methods are used in capital budgeting, including the techniques as followed:
Net present value Internal rate of return Payback period Profitability index Equivalent annuity Real options analysis
Net present value (NPV) is used to
estimate each potential project’s value by using a discounted cash flow (DCF) valuation.
The internal rate of return (IRR) is defined as
the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency.
Payback period in capital budgeting refers to
the period of time required for the return on an investment to “repay” the sum of the original investment.
Profitability index (PI), also known as profit investment ratio (PIR) and value investment ratio (VIR), is
the ratio of payoff to investment of a proposed project.
Other essential functions of a budget include:
To control resources
To communicate plans to various responsibility center managers
To motivate managers to strive to achieve budget goals
To evaluate the performance of managers
To provide visibility into the company’s performance
Accounting revolves around tracking the inflows and outflows of
assets, capital, and resources for an organization to adhere to legal and investor expectations.
When measuring the impact of assets, liabilities, and equity, it is useful to know
in which situations to debit or credit the line item based upon the flow of capital.
Cash flows analyses, such as the internal rate of return (IRR) or the net present value (NPV) of a given process, are
core tools in capital budgeting for understanding and estimating cash flows.
Cash flow analyses can include
investing, operating and financing activities.
Net present value (NPV):
This calculation takes all future cash flows from a given operational initiative, and discounts them to their present value based on the weighted average cost of capital.
Internal rate of return (IRR):
a calculation that makes the net present value of all cash flows (positive and negative) from a particular investment equal to zero. It can also be described as the rate which will make an investment break even.
The International Accounting Standards (IAS) and the Generally Accepted Accounting Principles (GAAP) are legislative descriptions of expectations and norms within the
accounting field.
A cash flow is one element of
accounting flows.
Investing activities
Payments related to mergers or acquisitions, loans made to suppliers or received from customers, as well as the purchase or sale of assets are all considered investing activities and tracked as incoming or outgoing cash flows.
Operating activities
Operating activities can be quite broad, incorporating anything related to the production, sale, or delivery of a given product or service. This includes raw materials, advertising, shipping, inventory, payments to suppliers and employee, interest payments, depreciation, deferred tax, and amortization.
Financing activities
Financing activities primarily revolve around cash inflows from banks and shareholders, as well as outflows via dividends to investors. This includes payment for repurchase of company shares, dividends, net borrowing and net repayment of debt.
The higher the NPV,
the more attractive the investment proposal.
The higher a project’s IRR,
the more desirable it is to undertake the project.
As the value of the profitability index increases, so does
the financial attractiveness of the proposed project.
Shorter payback periods are preferable to
longer payback periods.
The higher the ARR,
the more attractive the investment.
NPV formula:
Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore, NPV is the sum of all terms.
NPV and PI assume
reinvestment at the discount rate, while IRR assumes reinvestment at the internal rate of return.
If trying to decide between alternative investments in order to maximize the value of the firm,
the reinvestment rate would be a better choice.
NPV and PI assume reinvestment at the
discount rate.
IRR assumes reinvestment at the
internal rate of return.
Weighted average cost of capital:
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets.
Which definition is a correct description of a capital budgeting method?
The internal rate of return is the discount rate that gives a net present value of zero. The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency.
Which of the following is a function of corporate capital budgeting?
To rank projects by profitability - Capital Budgeting is most involved in ranking projects and raising funds when long-term investment is taken into account.
A firm is trying to choose the most profitable project to invest in. Which feature should be used as the company’s discount rate?
The company’s reinvestment rate. Selection of the discount rate is dependent on the use to which it will be put. If the intent is simply to determine whether a project will add value to the company, using the firm’s weighted average cost of capital may be appropriate. If trying to decide between alternative investments in order to maximize the value of the firm, the corporate reinvestment rate would be a better choice.
Which statement reflects the best reason to use the payback method to evaluate investments?
The payback method is easy to use and understandable for most people, regardless of training. Payback period is widely used because of its ease of use despite the recognized limitations: The time value of money is not taken into account.
Which investment proposal ranking method is widely used due to its simplicity, despite having several limitations?
Payback period. Payback period is widely used because of its ease of use despite several recognized limitations, such as not taking into account the time value of money.
