Capital Budgeting Flashcards
What is Capital Budgeting? How is it used?
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
What values are used in Capital Budgeting?
Capital Budgeting ONLY uses Present Value tables.
Capital Budgeting NEVER uses Fair Value.
When is the Present Value of $1 table used?
For ONE payment- ONE time.
When is the Present Value of an Annuity Due used?
Multiple payments made over time- where the payments are made at the START of the period.
When is the Present Value of an Ordinary Annuity of $1 (PVOA) used?
Multiple payments over time- where payments are made at the END of the period.
Think A for Arrears.
What is the calculation for the Present Value of $1?
1 / (( 1+i )^n)
i = interest rate n = number of periods
What is Net Present Value (NPV)?
A preferred method of evaluating profitability.
One of two methods that use the Time Value of Money
= PV of Future Cash Flows - Investment
How is NPV used to calculate future benefit?
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)
What is the rate of return on an investment called?
The Discount Rate.
What does the Discount Rate represent?
The rate of return on an investment used.
It represents the minimum rate of return required.
What are the strengths of the Net Present Value system?
Uses the Time Value of Money
Uses all cash flows- not just the cash flows to arrive at Payback
Takes risks into consideration
What are the weaknesses of the Net Present Value system?
Not as simple as the Accounting Rate of Return.
How do Salvage Value and Depreciation affect Net Present Value?
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.
If multiple potential rates of return are available- which is used to calculate Net Present Value?
The minimum rate of return is used.
What is the Internal Rate of Return (IRR)?
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
Which rate of return is used to re-invest cash flows for Internal Rate of Return?
Cash flows are re-invested at the rate of return earned by the original investment.
How does the rate used for Internal Rate of Return (IRR) compare to that used for Net Present Value (NPV)?
Rate of return for IRR is the rate earned by the investment.
Rate of return for NPV is the minimum rate.
What are the strengths and weaknesses of the Internal Rate of Return system?
Strengths: Uses Time Value of Money- Cash Flow emphasis
Weakness: Uneven cash flows lead to varied IRR
When is NPV on an Investment positive?
When the benefits are greater than the costs.
IRR is greater than the Discount Rate
When is NPV on an Investment Negative?
When Costs are greater than Benefits
IRR is less than the Discount Rate
What is the Payback Method? How is it calculated?
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.
When is NPV Zero?
When benefits equal the Costs
IRR = Discount Rate
What are the strengths of the Payback Method?
Takes risk into consideration
2 year payback is less risky than a 5 year payback
What are the weaknesses of the payback method?
Ignores the Time Value of Money
Exception: Discount payback method
Ignores cash flow after the initial investment is paid back
What is the Accounting Rate of Return?
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.
What are the strengths of the Accounting Rate of Return (ARR)?
Simple to use
People understand easily
What are the 6 stages of Capital Budgeting?
Capital budgeting is a technique used to evaluate and control long-term investments. The 6 stages of capital budgeting are:
- Identification stage
- Search stage
- Information-acquisition stage
- Selection stage
- Financing stage
- Implementation & control stage
What are the weaknesses of the Accounting Rate of Return (ARR)?
Can be skewed based on Depreciation method that is used.
Ignores the Time Value of Money.
What is an Expected Return?
An approximate rate of return on assets.
What is the Identification stage?
Capital budgeting stage
The Identification stage is the determination of types of capital projects necessary to achieve objectives & strategies
What is the Search stage?
Capital budgeting stage
The Search stage of capital budgeting is when management identifies alternative capital investments that will achieve its objectives
What is the Information-acquisition stage?
Capital budgeting stage
The Information-acquisition capital budgeting stage is when management evaluates various investments by performing cost vs. benefit analysis
What is the Selection stage?
Capital budgeting stage
The Selection capital budgeting stage is when management chooses the project/investment that meets their needs
What is the Financing stage?
Capital budgeting stage
The Financing capital budgeting stage is when management determines source of funding for project or investment it intends to undertake
What is the Excess Present Value (profitability) index?
The excess present value (profitability) index compares the ratio of the present value of the cash inflows to the initial cost of a project
This is used to evaluate the NPV of projects when there are limited funds
Investments / Projects with higher profitability indexes would be implemented first
PV of future net CFS / Initial Investment
x 100
= Excess present value (profitability) index
Lease vs. Buy Decisions
What types considerations one must take into account when dealing these decisions?
In capital budgeting, it is important to evaluate whether it may be more advantageous to lease the asset rather than purchase it. In making a lease vs. buy decision, management will often compare the two alternatives using discounted cash flow analysis. Depending on the circumstances, leasing may provide an attractive alternative for the following reasons:
- Tax advantages to structuring the acquisition as a lease
- Leasing may require less initial investment
- Leasing will require less formal borrowing, which may be restricted by loan covenants tied to the company’s other debt
- Certain leases do not have to be capitalized and therefore; will not require recognition of debt on the company’s balance sheet
What is the Implementation & control stage
Capital budgeting stage
The Implementation & control stage of capital budgeting is when management follows through with the project and monitors performance of the investment
What is the basic format for a Production budget?
The basic format for a production budget is as follows:
Budgeted sales
+ Desired ending FG inventory
= Total needs
- Beg. FG inventory
= Units to be produced
What is the basic format for a Direct Materials budget?
The basic format for a direct materials budget is as follows:
Units to be produced (from Production budget)
x DM per unit
= Production needs
+ Desired ending DM inventory
= Total needs
- Beg. DM inventory
= DM to be purchased (units)
x Price per unit
= DM purchases in dollars
What is the basic format for a Cash budget?
The basic format for a cash budget is as follows:
Beginning cash balance
+ Receipts (collections from customers, etc.)
= Cash available
- Payments (materials, expenses, payroll, etc.)
= Estimated cash balance BEFORE financing
+/- Financing (planned borrowing or short-term investing to bring cash to desired balance)
= Ending cash balance
