Capital Budgeting & Evaluation Techniques Flashcards
Define risk.
Risk is the possibility of loss or other unfavorable result that derives from the uncertainty implicit in future outcomes.
What does the presence of risk for a portfolio of projects mean?
Many outcome are possible.
Define risk-free rate.
Risk-free rate is the reward expected for deferring current consumption and does not change as the perceived risk of an undertaking increases (or decreases)
With regards to the risk-reward relationship graph, when the perceived risk of an undertaking increases, what would be the expected effect on the risk-free rate of return and the risk premium? You can look at graph in formula book to see the risk-reward graph.
Risk-free rate = No change. Risk-free rate is always constant and won’t change when perceived risk increases/decreases.
Risk premium = Increase. An increase in the risk premium would be expected as a result of an increase in perceived risk; it is the “reward” for risk. Thus, the greater the risk, the greater the expected reward (or risk premium).
On the risk-reward relationship graph which shows the relationship between financial risk and expected financial reward, the curve has a ______ slope. Why does it have a slop in this direction?
POSITIVE slope. The more perceived risk a financial investment or undertaking has, the higher the expected return associated with that risk.
Which rate identifies the rate of return required by investors to compensate them for deferring current consumption when making an investment? Also, this rate is the interest that would be charged on a borrowing that carried no risks (e.g., of default, inflation, etc.). This interest is required by lenders, not to cover risks, but to compensate the lender for deferring use of the funds by making an investment.
Risk-free rate
Review definitions for prime rate, discount rate, and effective rate.
Prime rate - interest rate that commercial banks charge their most creditworthy borrowers.
Discount rate - rate at which member banks may borrow short-term funds directly from a Federal Reserve Bank.
Effective rate - rate calculated as the interest received (or charged) divided by the actual cost of the investment (or loan).
Out of the four rates below, one rate charges interest on borrowing. Two rates charges interest on borrowing as well as including premiums for risks associated with making loan. Which rate is associated with interest only? Which two rates are associated with interest and premium?
Choices: Risk-free rate, effective rate, discount rate, and prime rate
Interest Only -Risk-free rate Intertest and Premium Only -Prime rate -Effective rate
Define capital budgeting.
Capital budgeting - Process of measuring, evaluating, and selecting long-term investment opportunities (or projects).
Does accounting rate of return consider time value of money? Yes or no.
No
An efficient portfolio is one that meets investor’s risk preference function which describes the investor’s tradeoff between _____ and ______.
Risk and return
Capital budgeting is based on predictions of an uncertain _______. All capital budgeting methods are based on predictions of ______ income or cash flows. (HINT: same word)
Future
What are three advantages to payback period, discounted cash flow, internal rate of return, and net present value method?
- All consider time value of money
- Don’t require multiple trial and error calculations
- They don’t require knowledge of a company’s cost of capital
(Re-check; may be incorrect)
What is one limitation of payback period, discounted cash flow, internal rate of return, and net present value method?
They rely on forecasting of future data (cash flows)
The relationship between risk and return is _____ or _______.
Direct or positive
This rate is commonly compared to internal rate of return to evaluate whether to make an investment? (Hint: provides a measure of the cost of the funds that the company is considering investing in a project)
Weighted-average cost of capital
This particular type of risk is the level of risk that concerns investors who supply capital to a diversified company. What is the name of this type of risk?
Weighted-average of project risk (betas). A diversified company can be thought of as an investment portfolio. The relevant risk for both management and investors is the weighted average of project risk.
The cost of capital is a composite, or weighted-average, of all financing sources in their usual proportions. It includes both the cost of ___________ and the cost of _________.
- Equity financing
2. After-tax cost of debt
When a company is financing with both debt and equity, the benchmark cost of capital should be? And why?
Weighted-average cost of capital. Because it incorporates all financing sources. Weights are determined by usual financing proportions.
Interest rates that have ______ over the past several years should encourage a company to use short-term loans.
Declined.
The payback period approach to assessing a capital project determines the # of years (periods) needed to recover the initial cash investment in the project and compares resulting time with pre-established maximum period. When would a project be deemed acceptable or unacceptable?
Project Acceptable: When expected payback period for project is less or equal to pre-established maximum
Project Unacceptable: When expected payback period is longer than established maximum.
Payback period approach determines the # of years needed to recover _________?
The initial investment amount
Quick simple payback period problem. Initial investment = $1,000. Below are the cash inflows for each year. What is the payback period? Year 1: $200 Year 2: $200 Year 3: $400 Year 4: $400
The answer is 3.5 years. It takes you this amount of time to accumulate the $1000 initial investment. (200 + 200 + 400 + 200) = $1,000 or 3.5 years.
What is the formula to calculate payback period of an investment?
Initial cash investment/net cash inflows = # of years needed to recover initial investment
What are three advantages of the payback period?
- Easy to understand and use
- Useful in evaluating liquidity
- Establishing short maximum period reduces uncertainty
What are four disadvantages of the payback period?
- Ignores time value of money
- Ignores cash flows after payback period
- Does not distinguish different sources of cash flow
- Not measure project profitability
Capital budgeting is concerned with capital investments that have prospects for ________ long-term benefits?
Long-term. Capital budgeting does not apply to short-term.
Which of the following approaches to capital project evaluation are concerned with determining economic feasibility of projects?
Choices: Net present value approach, profitability index approach, accounting rate of return approach, internal rate of return approach.
- Net present value approach
- Accounting rate of return approach
- Internal rate of return approach
This approach to capital project evaluation is primarily concerned with the relative economic ranking of projects by taking into account the cost of a project as well as with its net present value. What is it?
Profitability index approach
Regarding determining payback period, when you are given information relating to depreciation and time value of money, would these be considered in your calculation of payback period?
No. Time value of money is not included.
Depreciation is not included as well since it is not a cash inflow/outflow.
Formula: Initial cost/Net Cash Inflows
Regarding payback period, what is the formula to calculate initial investment of a project? You are given net cash inflows and payback period.
Initial cash investment = Net cash inflows x payback period
Regarding payback period, how do you calculate net cash inflows portion of payback period equation when you are given operating expenses and depreciation expenses?
Payback period = Initial cash investment/Net cash inflows (Operating expenses - Depreciation expenses)
What is the formula to calculate straight-line depreciation?
(Cost - Residual Value)/# of year of life = SL Depreciation expense per year
What is the formula to calculate sum-of-the-years digits depreciation?
Depreciable amount (Cost-Residual Value) x fraction of yr (5/15). **5 year example. 5+4+3+2+1= 15. 5/15 for year 1. 4/15 for year 2 and so on**
What is the formula to calculate double declining balance depreciation?
Beg. of period book value (Just cost; no residual value) x (2 x SL rate)
**5 year depreciation would be 20% SL rate. Therefore, 40% used (2 x 20%).
Double declining balance depreciation is calculated by doubling the straight-line rate and multiplying that rate by the declining book value each year.
What is the formula to calculate units of production depreciation?
(Cost - Residual Value)/# of total units x # of units yr 1
The units of production method is calculated by allocating the depreciable amount to production on a per unit basis and multiplying the resulting per unit rate by the level of production each period.
What are the advantages of discounted payback method? How do these compare to advantages for payback period?
Same advantages as payback period, however, it does consider time value of money.
- Easy to understand and use
- Useful in evaluating liquidity
- Establishing short maximum period reduces uncertainty
- Considers time value of money
What are the disadvantages of discounted payback method? How do these compare to advantages for payback period?
- Ignores cash flows after payback period
- Does not distinguish different sources of cash flow
- Not measure project profitability
* *Does measure time value of money**
Discounted payback method and payback method have same advantages and disadvantages, what is the one key difference?
Discounted payback method considers time value of money while the other doesn’t. Because of this it makes discounted payback method better.
