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BEC > Capital Budgeting > Flashcards

Capital Budgeting Flashcards

2
Q

What is Capital Budgeting? How is it used?

A

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

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3
Q

What values are used in Capital Budgeting?

A

Capital Budgeting ONLY uses Present Value tables.

Capital Budgeting NEVER uses Fair Value.

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4
Q

When is the Present Value of $1 table used?

A

For ONE payment- ONE time.

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5
Q

When is the Present Value of an Annuity Due used?

A

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

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6
Q

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

A

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

Think A for Arrears.

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7
Q

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

A

1 / (( 1+i )^n)

i = interest rate
n = number of periods
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8
Q

What is Net Present Value (NPV)?

A

A preferred method of evaluating profitability.

One of two methods that use the Time Value of Money

= PV of Future Cash Flows - Investment

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9
Q

How is NPV used to calculate future benefit?

A

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)

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10
Q

What is the rate of return on an investment called?

A

The Discount Rate.

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11
Q

What does the Discount Rate represent?

A

The rate of return on an investment used.

It represents the minimum rate of return required.

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12
Q

What are the strengths of the Net Present Value system?

A

Uses the Time Value of Money

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

Takes risks into consideration

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13
Q

What are the weaknesses of the Net Present Value system?

A

Not as simple as the Accounting Rate of Return.

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14
Q

How do Salvage Value and Depreciation affect Net Present Value?

A

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.

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15
Q

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

A

The minimum rate of return is used.

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16
Q

What is the Internal Rate of Return (IRR)?

A

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

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17
Q

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

A

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

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18
Q

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

A

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

Rate of return for NPV is the minimum rate.

19
Q

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

A

Strengths: Uses Time Value of Money- Cash Flow emphasis

Weakness: Uneven cash flows lead to varied IRR

20
Q

When is NPV on an Investment positive?

A

When the benefits are greater than the costs.

IRR is greater than the Discount Rate

21
Q

When is NPV on an Investment Negative?

A

When Costs are greater than Benefits

IRR is less than the Discount Rate

22
Q

What is the Payback Method? How is it calculated?

A

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.

23
Q

When is NPV Zero?

A

When benefits equal the Costs

IRR = Discount Rate

24
Q

What are the strengths of the Payback Method?

A

Takes risk into consideration

2 year payback is less risky than a 5 year payback

25
Q

What are the weaknesses of the payback method?

A

Ignores the Time Value of Money

Exception: Discount payback method

Ignores cash flow after the initial investment is paid back

26
Q

What is the Accounting Rate of Return?

A

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.

27
Q

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

A

Simple to use

People understand easily

28
Q

What are the 6 stages of Capital Budgeting?

A

Capital budgeting is a technique used to evaluate and control long-term investments. The 6 stages of capital budgeting are:

  1. Identification stage
  2. Search stage
  3. Information-acquisition stage
  4. Selection stage
  5. Financing stage
  6. Implementation & control stage
29
Q

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

A

Can be skewed based on Depreciation method that is used.

Ignores the Time Value of Money.

30
Q

What is an Expected Return?

A

An approximate rate of return on assets.

31
Q

What is the Identification stage?

Capital budgeting stage

A

The Identification stage is the determination of types of capital projects necessary to achieve objectives & strategies

32
Q

What is the Search stage?

Capital budgeting stage

A

The Search stage of capital budgeting is when management identifies alternative capital investments that will achieve its objectives

33
Q

What is the Information-acquisition stage?

Capital budgeting stage

A

The Information-acquisition capital budgeting stage is when management evaluates various investments by performing cost vs. benefit analysis

34
Q

What is the Selection stage?

Capital budgeting stage

A

The Selection capital budgeting stage is when management chooses the project/investment that meets their needs

35
Q

What is the Financing stage?

Capital budgeting stage

A

The Financing capital budgeting stage is when management determines source of funding for project or investment it intends to undertake

36
Q

What is the Excess Present Value (profitability) index?

A

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

37
Q

Lease vs. Buy Decisions

What types considerations one must take into account when dealing these decisions?

A

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:

  1. Tax advantages to structuring the acquisition as a lease
  2. Leasing may require less initial investment
  3. Leasing will require less formal borrowing, which may be restricted by loan covenants tied to the company’s other debt
  4. Certain leases do not have to be capitalized and therefore; will not require recognition of debt on the company’s balance sheet
38
Q

What is the Implementation & control stage

Capital budgeting stage

A

The Implementation & control stage of capital budgeting is when management follows through with the project and monitors performance of the investment

39
Q

What is the basic format for a Production budget?

A

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

40
Q

What is the basic format for a Direct Materials budget?

A

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

41
Q

What is the basic format for a Cash budget?

A

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

BEC (9 decks)

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