Capital budgeting Flashcards
What does it mean to have a benefit-cost ratio greater than 1?
It means that the present value of benefits is greater than the present value of costs
You have to recommend one alternative from two or more alternatives. If your recommendation has to be based on the benefit-cost ratio, you would select the alternative with:
The highest benefit-cost ratio
One principal reason to finance capital improvement by borrowing instead of paying from resources on hand is
Borrowing helps to distribute costs across generation and future residents
Debt is usually less expensive than giving up equity
Debt can be cheaper than your opportunity cost.
Paying interest on debt reduces tax burden
Governments use debt financing to
Cover deficits of annual expenditures
State and local governments use many different debt instruments because:
They sometimes seek to evade statutory or constitutional debt limits
Revenue bonds are backed by the
The specific revenues generated by the project being financed
What is capital budgeting?1
Capital budgeting is the process by which capital budgets become planning and policy instruments used by states and local governments in guiding investment in long-life fixed assets
What is capital budgeting?
the process used to evaluate and determine potential expenses or investments in large projects such as:
1) building a new plant
2) investing in a long-term venture
3) buying another company
What is the payback period approach?
length of time required to recover the cost of an investment
What are two advantages of used the payback period?
1) useful in evaluating project liquidity
2) short payback period reduces uncertainty
What are two disadvantages of using the payback period?
1) ignores TVM
2) does not measure total project profitability
How do you calculate the payback period?
years = initial investment / ANNUAL after-tax net cash flow (or savings)
How do you calculate the ANNUAL after-tax net cash flow?
CF - cash expenses + non-cash expenses
How does depreciation affect ANNUAL after-tax net cash flow?
its ignored (i.e. added back) to the extent depreciation expense is tax deductible which is called a tax shield
How do you calculate the tax shield for depreciation?
tax shield is ADDED back to ANNUAL after-tax net cash flow
= depreciation expense x tax rate %
Does the residual value affect considered in the payback period approach?
no, its ignored
What is the internal rate of return (IRR) approach and why is it used?
1) discount rate at which an investments NPV of all cash flows equals zero
2) to evaluate the attractiveness of a project or investment
What is the advantages of using the IRR?
takes into account a projects total profitability by discounting all projected CF using the hurdle interest rate
What are three disadvantages of using the IRR?
) requires estimation of CF over the entire life of project, which could be very long
2) requires all CF be either inflows or outflows
3) assumes CF from the project are immediately reinvested at the project’s IRR
What is the IRR compared to in order to determine if a project should be accepted or not?
hurdle rate
What is the hurdle rate?
the lowest acceptable rate of return on investment (aka the cost of capital)
What is the accounting rate of return approach? (ARR)
measures expected annual accounting income from a project as a percentage of the initial (or average) investment
What is the net present value approach? (NPV)
difference between PV of cash inflows and PV of cash outflows (typically the investment made today)
What are two advantages of using the NPV?
1) relates project rate of return to cost of capital
2) considers the entire life and results of project
