Capital Budgeting Into & Project Risk Flashcards
Project Ranking Decisions
Resource constraints (in short-run); must allocate resources to most beneficial projects
PPA
Payback period approach - ranks projects based on how quickly invested capital is recovered;
Uses nominal dollars, not discounted
DPP Discounted payback period approach
How quickly invested capital is recovered using discounted cash flows;
Accounting rate of return ARR
Annoaul incremental accrual-baed net income as a percentage of initial investment;
Higher percent = higher ranking
Uses accrual value not cash flows
NPV - Net present value approach
Ranks projects based on there relative net present values
Higher net present value = Higher ranking
Recognizes the time value of money
IRR - Internal rate of return approach
Higher internal rate = higher ranking
It recognizes the time value of money
IRR VS NPV -
May result in different rankings due to differences in:
1) Project investment cost
2) timing of cash flows
3) life of project
PI Approach
Profitability index approach - Ranks base on net present value of each project as a percentage of initial investment cost of each
Capital Budgeting
Process of measuring, selecting, and evaluating log-term investment opportunities
Project Risks
Risk = possibility of loss or other unfavorable result resulting from implicit future decisions
Reward - Benefit expected or required from investment in capital project (greater perceived risk, the greater the reward)
Risk-Reward Relationship
Expected Reward = Y; Perceived Risk = X
Disount/Hurdle Rate
As described in the “Cost Concepts” section, while the cost of capital can be determined for each element of capital (e.g., long-term notes, bonds, preferred stock, common stock, etc.), it is usually appropriate to calculate and use the weighted average cost of capital. Specifically, the cost of capital for each element is weighted by the proportion of total capital provided by each element. The resulting weighted average is the rate of return that a firm must expect to earn on a project it undertakes. In evaluating projects, that rate is called the hurdle rate or discount rate.
