Capital Investment Decisions Flashcards
What are capital investment decisions?
Capital investment decisions, also known as capital budgeting, involve evaluating and selecting long-term investments that require substantial initial funding. These investments are aimed at generating returns over an extended period.
Why are capital investment decisions important?
Capital investment decisions are critical because they:
1. Involve large, often irreversible expenditures.
2. Affect the company’s long-term growth and competitiveness.
3. Influence future cash flows and profitability, directly impacting shareholder value.
What is Net Present Value (NPV)?
NPV measures the profitability of an investment by calculating the difference between the present value of cash inflows and cash outflows.
What is the Internal Rate of Return (IRR)?
IRR is the discount rate at which the NPV equals zero, meaning the project breaks even.
IRR stands for Internal Rate of Return, and it is the discount rate at which the Net Present Value (NPV) of a project equals zero. In simpler terms, it is the rate of return that makes the present value of future cash inflows equal to the initial investment. It tells us the break-even cost of capital for a project.
What is the decision rule for NPV?
Accept if NPV > 0: The project adds value and increases shareholder wealth.
Reject if NPV < 0: The project reduces value and is not financially viable.
Accept or reject if NPV = 0: The project does not reduce or add value. If the project provides intangible benefits it may be accepted.
Choose highest NPV for exclusive projects: Maximizes overall profitability.
What is the decision rule for IRR?
Accept if IRR > Required Rate of Return: The project is expected to generate returns higher than the minimum acceptable rate.
Reject if IRR < Required Rate of Return: The project’s returns do not meet the required threshold.
Choose highest IRR for exclusive projects: When comparing projects, select the one with the highest IRR, provided it exceeds the required rate.
What is the Profitability Index?
Profitability Index is the ratio of the present value of future cash inflows to the initial investment. It helps compare projects of different sizes.
Profitability Index =
Present value of future cash inflows / Initial Investment
What is the decision rule for the Profitability Index?
Accept if PI > 1: The project generates more value than its cost, indicating profitability.
Reject if PI < 1: The project’s costs exceed its benefits, making it unviable.
Choose highest PI for exclusive projects: Prioritize projects with the highest PI to maximize value.
What is the Payback Period?
The payback period measures how long it takes to recover the initial investment.
What is the simple Payback Period?
The simple Payback period is not accounting for the discounted cash flows.
Payback Period = Initial Investment / Annual Cash Inflow
What is the Dynamic Payback Period?
The Dynamic Payback Period includes the discount rate, resulting in discounted cash inflows being used.
Payback Period = Initial Investment / Annual Cash Inflow
What is time value of money?
Time value of money recognizes that money today is worth more than the same amount in the future due to its earning potential.
Present Value = Future Value / (1+r)^t
Future Value = Present Value / (1+r)^t
When should you use each Capital Investment Decision method?
When to Use Each Method
* NPV: Best for evaluating profitability in absolute terms.
* IRR: Useful for understanding percentage returns.
* PI: Ideal for comparing projects with different scales.
* Payback Period: Good for assessing risk and liquidity needs.
