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MN20501- Intermediate Accounting > Capital Budgeting Techniques > Flashcards

Capital Budgeting Techniques Flashcards

1
Q

What does capital budgeting involve?

A

Involve significant outlays in the current year in return for a stream of benefits in future years

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2
Q

What is there between teh time of the investment and teh returns of the investment?

A

Long time gap between outlay and its recoupment

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3
Q

Is capital easy to reverse?

A

Not easy to reverse a capital investment once it has been undertaken; aborting capital investment may involve additional cost

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4
Q

What are the two broad capital investment decisions? What are these?

A
  • Screening decisions
    -Does a proposed investment meet a pre-set criteria of acceptance?
  • Preference/choice decisions
    -Which is the best project out of a number of competing alternatives?
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5
Q

What are some assumption we make to simplify the unit?

A
  • All cash inflows and outflows occur at year end
  • All cash inflows and cash outflows are known with certainty
  • No taxes
  • No inflation
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6
Q

How can we categorise investment appraisal techniques and what are in these categories?

A

Based on non-discounted cash flow:
* Accounting rate of return (ARR)
* Payback period

Based on discounted cash flow:
* Discounted payback period
* Net present value (NPV)
* Internal rate of return (IRR)

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7
Q

Define relevant cash flows.

A

Incremental future revenues and
cash-related costs
i.e., avoidable if project is not undertaken

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8
Q

What are the relevant cash flows in an investment appraisal? What does it not include?

A

 Opportunity costs
 Cost savings

 Sunk costs
 Depreciation (not cash)

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9
Q

In year 0, what tends to be the initial outlay cashflows?

A
  • Initial asset investment (-)
  • Initial working capital requirements (-)
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10
Q

What tends to be the cash flows during the lifespan of the project (Y1-Yn)?

A
  • Cash inflows from sales (+)
  • Cash outflows to pay for operating costs (-)
  • Cash savings (+)
  • Opportunity costs (-)
  • Any other incremental cash inflows and/or outflows
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11
Q

What tends to be the cash flows at the end of the project, Yn?

A
  • Estimated proceeds from disposal if asset is sold (+)
    – usually the scrap value/residual value
  • Initial investment in working capital is usually fully
    recovered when the project is terminated (+)
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12
Q

How do we calculate the accounting rate of return (ARR)?

A

ARR = Average annual profit / Average investment

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13
Q

How do we calculate average annual profit?

A

= (Sum of Expected net cash flows during the project* - Total Depreciation)/Life of the project in Years
*this excludes proceeds from disposal of non-current asset at the end of the project

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14
Q

How do we calculate average investment?

A

Average investment = (Initial investment cost + residual value)/2

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15
Q

When using ARR, what do we need to account for?

A

Depreciation

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16
Q

What is the screening decision for ARR?

A

Project should meet internally set minimum ARR %

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17
Q

What is the choice decision for ARR?

A

Choose project with the higher ARR %

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18
Q

What are the advantages of ARR?

A

Conceptually similar to return on capital employed which is commonly used by business analysts

Both ARR and ROCE relate operating profits to the investment
required to generate said profit
* ARR assesses the performance of a given investment before it has performed; ROCE assesses historical performance
* ARR can be thought of as a target ROCE %

Allows assets/projects with different useful lives to be compared

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19
Q

What are the limitations of ARR?

A

Doesn’t consider the timing of cash flows- the time value of money is not considered.

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20
Q

What is the payback period?

A

The time it takes for the initial outlay to be recouped from net cashflows during the project’s life

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21
Q

Does the payback period consider the timing of cash flows?

A

Yes

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22
Q

How do you calculate payback period?

A

Calculate cumulative cash flows at the end of each year
CCF Year 0 = Year 0 Cashflow
CCF Year 1 = Year 0 Cashflow + Year 1 Cashflow
And so on…when the CCF is > 0 the initial outlay has been recouped

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23
Q

What is the screening decision for payback period?

A

If the project’s payback period exceeds internally set maximum payback period, then reject

24
Q

What is the choice decision for payback period ?

A

Choose project with the shorter payback period

25
Q

What is the assumption of payback period that allows us to calculate the exact payback period?

A

Cash flows for a year are spread evenly over 12 months

26
Q

What are the advantages of payback period?

A

Easy to calculate

Easy to understand

Focuses on liquidity, a constraint for many businesses.

Projects where initial outlays can be recouped quickly are more appealing than those with longer payback periods

Indirectly accounts for uncertainty of later cash flows by ignoring cash flows after payback is achieved

27
Q

What are the limitations of payback period?

A

Does not fully consider the timing and amount of cash flows over the life of the project - ignores cash flows after the payback period

Not concerned with overall profitability of the investment

Deals with uncertainty of later cashflows in a relatively simplistic manner by favouring projects with shorter payback periods

Ignores the time value of money:

28
Q

How can we improve on the payback period?

A

Calculate the discounted payback period- time value of money is included

29
Q

What does the time value of money say?

A

A £1 today is worth more than a £1 tomorrow

30
Q

What can we do with future cash flows?

A

Calculate the PV through discounting

31
Q

What is the PV formula?

A

PV = FV/(1+r)^n

32
Q

What do the PV tables show us?

A

Present value tables shows the present value of £1 received in n years from now at various interest rates

33
Q

What is the interets rate of a company called?

A

Cost of capital

34
Q

What is the discount factor?

A

PV of a £ for a certain number of years

35
Q

What are the advantages of discounted payback period?

A

Relatively easy to calculate and understand

Takes into account time value of money

36
Q

Why is the discounted payback period always longer than the payback period?

A

As later cash flows are discounted more compared to earlier cash flows

37
Q

What are the limitations of the discounted payback period?

A

However, like the simple payback period, the
DPP method also ignores cash flows after the
(discounted) payback period

Accuracy of DPP depends largely on interest
rate chosen – what is the appropriate interest
rate to use?

Contradictory assumptions in DPP
* To discount future cash flows back to the
present, we assume all cash flows occur
at year end
* To work out a more exact (discounted)
payback period, we assume cash flows
are spread evenly throughout the year

38
Q

How do we calculate net present value (NPV)?

A

NPV = PV of all future cash flows – initial outlay

39
Q

What are the screening decisions for NPV?

A
  • If the project’s NPV > 0, then it is
    acceptable as it would increase
    shareholder’s wealth
  • If NPV = 0, still acceptable as it would not
    decrease shareholder’s wealth
  • If NPV < 0, reject the project as it would
    decrease shareholder’s wealth
40
Q

What is the choice decision for NPV?

A

Choose the project with the highest NPV

41
Q

What are the advantages of NPV?

A

Considered the most theoretically superior and logical investment appraisal method
* Considers all cash flows over the project life – can deal with projects with unconventional cash flows
* Incorporates the time value of money
* Aligned with shareholder’s objectives: wealth
maximisation
* Relatively easy to compare NPV of different projects and to reject projects with negative NPV

42
Q

What are the limitations of NPV?

A

Difficulties in estimating future cash flows –
common issue for all investment appraisal
methods

Not easy to select appropriate interest rate –
common issue for all investment appraisal
methods based on discounted cash flows

43
Q

What is the cost of capital said to be?

A

The opportunity cost of the shareholders’ funds to be invested in the project

44
Q

What is the opportunity cost interest rate said to be?

A

More than one possible answer:
* The interest rate that could be earned if the funds were invested in another company, or say government bonds – what are the opportunities available outside the company?
* The interest rate that could be earned if the funds were invested in existing projects in the company

45
Q

Why can the cost of capital be difficult to determine?

A

Need to incorporate risk premium – the riskier the project, the higher the required return.

46
Q

What is the internal rate of return (IRR)?

A

Similar to NPV
But instead of using a pre-determined interest
rate, IRR involves estimating, by trial and error,
the interest rate at which NPV equals zero

47
Q

Look at slides to see diagrams for interpreting IRR

A
48
Q

The lower the interest rate…

A

The higher the NPV

49
Q

How can you approximate NPV?

A

Calculate two interest rates NPV on a diagram and draw a line connecting them. Where NPV =0 is IRR.

50
Q

What is the formula for IRR?

A

Look at slides

51
Q

What is the screening decision for IRR?

A
  • Project must at least meet internally set IRR, if not reject
  • What should this minimum IRR be? Varies across businesses and industries
52
Q

What is the choice decision for IRR?

A

Choose project with the higher IRR

53
Q

What are the advantages of IRR?

A

Similar to NPV, all cash flows of the project are taken into account

IRR can be compared directly to an internal “hurdle” rate, usually returns foregone from other available opportunities in the financial markets instead of the project, i.e., opportunity cost of capital
* If IRR of the project is higher than the opportunity
cost of capital, then the project can be accepted

54
Q

What are the limitations of IRR?

A

Laborious to calculate

Cannot be determined directly, only an approximate IRR can be determined via interpolation

Unlike NPV, IRR does not directly address wealth maximisation. IRR is expressed in percentage form, thus obscuring the scale of each investment opportunity and how much would shareholder wealth increase/decrease in absolute terms.

Where unconventional cash flow occur (i.e.,
anything other than initial cash outflow followed by successive cash inflows), multiple IRRs (or even no IRR) may be possible

IRR implicitly assumes that cashflows generated from an investment project could be reinvested at the IRR
* Not very realistic compared to NPV which
assumes reinvestment at cost of capital

55
Q

Can IRR and NPV give different answers?

A

IRR and NPV can produce conflicting
rankings

MN20501- Intermediate Accounting (6 decks)

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