Capital_Budgeting

Question 1

What is Capital Budgeting? How is it used?

Answer 1

• 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

Question 2

What values are used in Capital Budgeting?

Answer 2

Capital Budgeting ONLY uses Present Value tables

Capital Budgeting NEVER uses Fair Value.

Question 3

When is the Present Value of $1 table used?

Answer 3

For ONE payment- ONE time.

Question 4

When is the Present Value of an Annuity Due used?

Answer 4

Multiple payments made over time

where the payments are made at the START of the period.

Question 5

When is the Present Value of an Ordinary Annuity of $1 (PVOA) used?

Answer 5

Multiple payments over time

Where payments are made at the END of the period.

Think A for Arrears.

Question 6

What is the calculation for the Present Value of $1?

Answer 6

1 / (( 1+i )^n)

i : interest rate

n: number of periods

Question 7

What is Net Present Value (NPV)?

Answer 7

A preferred method of evaluating profitability.

One of two methods that use the Time Value of Money:

NPV= PV of Future Cash Flows - Investment

Question 8

How is NPV used to calculate future benefit?

Answer 8

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)

Question 9

What is the rate of return on an investment called?

Answer 9

The Discount Rate.

Question 10

What does the Discount Rate represent?

Answer 10

The rate of return on an investment used.

It represents the minimum rate of return required.

Question 11

What are the strengths of the Net Present Value system?

Answer 11

• Uses the Time Value of Money
• Uses all cash flows- not just the cash flows to arrive at Payback
• Takes risks into consideration

Question 12

What are the weaknesses of the Net Present Value system?

Answer 12

Not as simple as the Accounting Rate of Return.

Question 13

How do Salvage Value and Depreciation affect Net Present Value?

Answer 13

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.

Question 14

If multiple potential rates of return are available- which is used to calculate Net Present Value?

Answer 14

The minimum rate of return is used.

Question 15

What is the Internal Rate of Return (IRR)?

Answer 15

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 (i.e.,
the rate that results in a NPV of zero).

PV Factor = Investment / After Tax Annual Cash Inflow

Question 16

Which rate of return is used to re-invest cash flows for Internal Rate of Return?

Answer 16

Cash flows are re-invested at the rate of return earned by the original investment.

Question 17

How does the rate used for Internal Rate of Return (IRR) compare to that used for Net Present Value (NPV)?

Answer 17

Rate of return for IRR is the rate earned by the investment.

Rate of return for NPV is the minimum rate.

The relationship between the NPV method and the IRR method can be summarized as follows:
NPV IRR
NPV > 0 IRR > Discount rate
NPV = 0 IRR = Discount rate
NPV < 0 IRR < Discount rate

Question 18

What are the strengths and weaknesses of the Internal Rate of Return system?

Answer 18

Strengths: Uses Time Value of Money- Cash Flow emphasis

Weakness: Uneven cash flows lead to varied IRR

Question 19

When is NPV on an Investment positive?

Answer 19

When the benefits are greater than the costs.

IRR is greater than the Discount Rate

Question 20

When is NPV on an Investment Negative?

Answer 20

When Costs are greater than Benefits

IRR is less than the Discount Rate

Question 21

When is NPV Zero?

Answer 21

When benefits equal the Costs’

IRR = Discount Rate

Question 22

What is the Payback Method? How is it calculated?

Answer 22

Payback Method = Investment / Annual Cash Inflow

• It measures an investment in terms of how long it takes to recoup the initial investment via Annual Cash Inflow
• 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.
• All cash flows occurring after the payback period are ignored.

Question 23

What are the strengths of the Payback Method?

Answer 23

Takes risk into consideration

2 year payback is less risky than a 5 year payback

Question 24

What are the weaknesses of the payback method?

Answer 24

• Ignores the Time Value of Money Exception: Discount payback method
• Ignores cash flow after the initial investment is paid back

Question 25

What is the Accounting Rate of Return?

Answer 25

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.

Question 26

What are the strengths of the Accounting Rate of Return (ARR)?

Answer 26

Simple to use - People understand easily

Question 27

What are the weaknesses of the Accounting Rate of Return (ARR)?

Answer 27

• Can be skewed based on Depreciation method that is used.
• Ignores the Time Value of Money.

Question 28

What is an Expected Return?

Answer 28

An approximate rate of return on assets.

Question 29

Net Present Value

Answer 29

Net present value = Present value of future inflows - Initial investment (Present value of outflows)

The Net Present Value Method adjusts for the time value of money. It seeks to determine whether the present value of the estimated net future cash inflows at a desired (or required) rate of return will be greater or less than the cost of the proposed investment. Using this method, initial investment, net cash inflows (or cash savings), and the discount rate are givens. The present value (PV) of the net cash inflows is calculated and compared to the initial investment. An investment proposal is desirable if its net present value (NPV) is positive. In other words, the present value of the future cash inflows is greater than the cost of the investment. A positive net present value indicates that the project’s rate of return is greater than the discount (bundle) rate of interest.

Question 30

The discount rate (or hurdle rate)

Answer 30

The discount rate (or hurdle rate) is the required internal rate of return for projects considered by a company or investor. This rate is often based upon a company’s weighted-average cost of capital, incorporating a risk premium related to the riskiness of the project in question. In other words, this rate must reward the investor for the risk that is being assumed when undertaking the investment.

Discount rates are used in net present value and internal rate of return calculations.

Question 31

Capital Budgeting

Answer 31

Capital budgeting is the analysis of investment decisions concerning plant facilities and equipment that have a useful life of more than one year, the allocation of resources to investment opportunities in an attempt to obtain the maximum return to the firm, and long-term planning decisions regarding the acquisition and financing of investments.

Capital budgeting attempts to answer questions like the following:

Is this machine profitable?
Which of these machines is most profitable?
Is it profitable to add a product, segment, or new market?
Should a research and development (or advertising, etc.) project be implemented?
Should existing debt be extinguished?

Relevant data for capital budgeting is cash-flow (future) oriented. Past (sunk) costs are irrelevant. Accrual accounting (i.e., depreciation) is irrelevant, although the tax effect of depreciation is relevant.

Relevant data includes:

initial investment required,
future net cash inflows or net savings in cash outflows, and
gain or loss on the disposal of old equipment.

Approaches to capital budgeting commonly used include:

net present value,
time-adjusted rate of return,
payback period,
accounting rate of return, and
internal rate of return.

Question 32

Internal rate of return (IRR)

Answer 32

Internal rate of return (IRR) is the method used to determine the rate of return that causes the present value of the net cash flows to equal the initial investment. It is a way of evaluating an investment as the present value of the net future cash flows from the investment, expressed as:

Investment = PV (i,t)

…where i (the rate at which the cash flows are discounted) is unknown.

An acceptable or beneficial proposal is one for which the IRR is equal to or greater than the firm’s predetermined minimum acceptable rate of return on the investment.

Question 33

Payback Method

Answer 33

Initial Investment
Payback Period = ——————————-

Annual Cash Flow

The payback period method does not adjust for the time value of money. It computes the length of time required to recover the initial cash investment with net cash flows. When the annual cash flows are equal, the payback period is computed by dividing the initial investment by the annual cash flow. If the annual cash flows are not equal, they are accumulated until the cumulative amount equals the initial investment.

The chief limitation is that the payback method emphasizes liquidity and disregards profitability.

The investment alternatives with the shortest period are considered most desirable.

The payback period serves as a fair approximation of the annuity factor value from the table of present values of an annuity.

Question 34

Accounting Rate of Return

Answer 34

Accounting rate of return = (Net cash inflow - Depreciation) ÷ Investment OR = Net income ÷ investment.

Accounting rate of return is a nondiscounted method of computing the rate of return of an investment. It is based on accrual accounting and has the measurement of profitability as the goal. The limitation of this method, however, is that it ignores the time value of money.

The capital budgeting model that is generally considered the best model for long-range decision making is the discounted cash flow model because the time value of money (present and future values) is considered.

Question 35

Profitability Index

Answer 35

The Profitability Index is calculated by dividing the present values of the cash flows after the initial investment by that investment. It takes both the size of the original investment and the value of the discounted cash flows into account.

Present Value of Cash Flows
After Initial Investment
Profitability Index = ————————————-
Initial Investment

This allows the comparison of various projects with differing initial investment amounts.

Note that any project with a positive NPV will, by definition, have a Profitability Index greater than 1.

The Profitability Index is often used to compare two or more mutually exclusive projects. Potential projects might be mutually exclusive in that they represent viable options to accomplish the same task. Other constraints might include a limited capital budget or lack of adequate resources to accomplish multiple projects. The alternative project with the highest profitability index is the most desirable.

The profitability index provides a means to rank capital projects.

This method is considered superior to accounting rate of return, payback, and internal rate of return because it gives full weight to the time value of money and provides a ranking of project profitability.

The profitability index is a more realistic ranking tool than internal rate of return because it assumes reinvestment at cost of capital rather than at the internal rate of return. This is particularly important when capital is rationed.

Question 36

​Discounted cash flow

Answer 36

Discounted cash flow is forecasted future cash flows, discounted (at an appropriate rate) to reflect present value. This is one method used in business valuation. Because this method involves financial forecasts, it is not widely used in valuing small businesses. When using financial forecasts, the practitioner needs to follow AICPA guidelines for prospective financial information.