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BEC > Capital Budgeting Chapter 3 > Flashcards

Capital Budgeting Chapter 3 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

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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7
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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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 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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11
Q

What is the rate of return on an investment called?

A

The Discount Rate.

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12
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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13
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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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

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

Factor of the IRR =
Net incremental inv. (invest. required)/Net annual CF
(Investment/CF)

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16
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.
Although the NPV method highlights amounts, the IRR method focuses decision makers on percentage.

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17
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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18
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

The IRR method has several limitations including unreasonable reinvestment assumption (cash flows reinvested at the IRR), inflexible cash flow assumptions (alternating positive and negative cash flow’s create IRR errors), and it is a relative measure that is compared to a hurdle rate (versus NPV which provides the absolute dollar contribution of the project).

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19
Q

When is NPV on an Investment positive?

A

When the benefits are greater than the costs.

IRR is greater than the Discount Rate

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20
Q

When is NPV on an Investment Negative?

A

When Costs are greater than Benefits

IRR is less than the Discount Rate

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21
Q

When is NPV Zero?

A

When benefits equal the Costs

IRR = Discount Rate or Hurdle Rate

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22
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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23
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.

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 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.

29
Q

What is an Expected Return?

A

An approximate rate of return on assets.

30
Q

What are the 3 general stages of cash flows?

A 
1. CF @ Inception of the Project (time period zero)
Todays Cost = initial outflow
2. Operating CF
Future OCF (annual) = inflow
3. CF from the  Disposal of the Project
One time terminal year CF = inflow
31
Q

Define Sunk Costs

A

Are those costs that have already been incurred, are unavoidable in the future, and will not vary with the course of action taken.

32
Q

What is the formula for after-tax cash flow?

A

(1 - tax rate) X Pre-Tax CF = After-tax CF

33
Q

What is the formula for computing a depreciation tax shield?

A

Tax rate X Depreciation deduction = Tax Savings from depreciation tax shield

34
Q

What approaches can management take to select the desired rate of return for a project?

A
  1. Use a Weighted-Average Cost of Capital (WACC) method
  2. Assign a target rate for new projects
  3. Recommend that the discount rate be related to the risk of the project
35
Q

Define net present value (NPV)

A

NPV = the difference between the PV of cash inflows and outflows from a project.

36
Q

How are investment decision made using the NPV method?

A

If NPV is positive, the investment should be made. If NPV is negative, the investment should not be made

37
Q

What is a hurtle rate?

A

In capital budgeting, hurdle rate is the minimum rate that a company expects to earn when investing in a project. Hence the hurdle rate is also referred to as the company’s required rate of return or target rate. In order for a project to be accepted, its internal rate of return must equal or exceed the hurdle rate.

38
Q

What the steps to calculate the NPV of an investment?

A

Step 1 - Calculate after-tax CF = Annual net CF X (1 - tax rate)
Step 2 - Add depreciation benefit = Depreciation X tax rate
Step 3 - Multiply result by appropriate PV of an annuity
Step 4 - Subtract initial cash outflow
Step 5 - NPV

39
Q

What is the profitability index?

A

The profitability index (PI) divides the PV of the net future cash flow’s by the initial investment. The profitability index is computed for each project alternative with each project ranked in order of the highest score. Projects with a PI

40
Q

One example of indirect effect of a transaction associated with a capital project would be…

A

Net proceeds on sale of asset reducing the cost of a new asset.

41
Q

How does an asset abandonment is treated in the initial investment of a new asset?

A

If the replaced asset is abandoned, the net salvage value is treated as a reduction of the initial investment in the new asset. The abandoned asset’s BV is considered a sunk cost, and therefore not relevant to the decision-making process. The remaining BV (for tax purposes) is deductible as a tax loss, which reduces the liability in the year of abandonment. this tax liability decrease is considered a reduction of the new asset’s initial investment.

42
Q

How is the sale on an asset treated in the investment of the new asset?

A

If a new asset acquisition requires the sale of old assets, the cash received from the sale of the old asset reduces the new investment’s value.

43
Q

What is included in the initial outflow of a project - Step 1?

A

Cost + shipping + install
+ increase in WC (out)
- net proceeds of old (in)
= Net Outflow

44
Q

What is in include in the ongoing operations cash inflows of a project - Step 2?

A

Pretax CF X (1 –T)
+ Depr X T (Depr. Tax shield)
= Annual net inflows

45
Q

What is included in the terminal year of a capital project?

A

Pretax CF X (1 – T) inflow
+ Depr. WC inflow
- Gain x T outflow - salvage val. or disposal cost
+ Loss x T inflow - salvage val. or disposal costs
= Net inflows

46
Q

Why is the NPV method of capital investment valuation is considered superior to IRR?

A

Because it is flexible enough to consistently handle either uneven cash flows or inconsistent rates of return for each year of the project.

47
Q

What is capital rationing?

A

How limited resources are ranked. If unlimited capital, all investment alternatives with a positive NPV should be pursued. If limited, managers will allocate capital to the combination of projects with the maximum NPV. The ranking of projects that exceed the hurdle rate is best accomplished using the profitability index.q

48
Q

What is the payback period method?

A

This method calculates the time it will take to recover the initial investment, disregarding the time value of money. The advantages of the payback period method are that it is easy to use and understand and that it emphasizes liquidity. , The payback period method ignores the time value of money and total project profitability (cash flows after the payback period). Ignore salvage value.

49
Q

What is the payback period formula when cash flow is NOT constant for each period?

A

A cumulative approach is taken to determine the payback period is used

Ex. Initial outflow $200, the increase in cash flows is as follows:
Y1 - $90
Y2 - $80
Y3 - $75

200 - 90 - 80 = 170 all of Y1 - Y2
200 - 170 = 30 part of Y3
30/75 = .4
The payback period will be 2.4 years

50
Q

What is the payback period formula when cash flow is constant for each period?

A

Net initial investment /
increase in annual net after-tax cash flow.

reduction annual oper. costs X (1 - T rate)
+ Depreciation X Tax rate
or
Expected cash flows savings
- (NI increase - depreciation) X tax rate

51
Q

What are the limitations of the payback method?

A
  1. The time value of money is ignored.
  2. Cash flows after the initial investment is recovered are not considered.
  3. Reinvestment of cash flows is not considered.
  4. Total project profitability is neglected
52
Q

Describe the Discounted Payback Method Breakeven time method (BET)?

A

This method uses PV factors to discount the expected cash flows. This method also ignores the total profitability of the entire project. When deciding weather accepting or rejecting a project. If the sum of PVFCF > today’s cost = profit (accept).

53
Q

What are the advantages and limitations of Discount Payback?

A

They are the same as the payback method, (except that the discount method incorporates the time value of money, a feature ignored by the payback method). Both focus on how quickly he investment is recouped rather than overall profitability of the entire project.

54
Q

What are the common projects using discount (BET) method?

A

It is often used to evaluate new product development projects of companies that experience rapid technological changes.

55
Q

How do you calculate the Discount (BET) Mehod?

A
  1. Calculate the PV of future cash flows
  2. Determine the Discount Payback Period
    See pg 19

BEC (10 decks)

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