Ch 11 - Capital Budgeting & Investment Analysis Flashcards
what is the capital expenditures budget?
managements plan for acquiring and selling plant assets
define capital budgeting
process of analyzing long-term investments an deciding which assets to acquire or sell
what are four reasons why many of capital budgeting decisions are risky
- outcome is uncertain
- large amounts of money are usually involved
- investment involves a long-term commitment
- decision could be difficult or impossible to reverse, no matter how poor turns out to be
what do nearly all of the methods to evaluate capital budgeting decisions include?
- predicting inflow/outflows of cash for proposed investments
- assessing risk of and returns on the cash flows
- choosing investments to make
Is a dollar tomorrow worth more or less than a dollar today?
dollar tomorrow is worth less than a dollar today
define discounting
process of restating future cash flows in terms of their present value
define net cash flow
cash inflows minus cash outflows
what are the two most common methods of analyzing financial feasibility of investments net cash flow w/out using time value of money
- payback period
2. accounting rate of return
define payback period (PBP)
expected time period to recover initial investment amount
define even cash flows
cash flows that are same each and every year
define uneven cash flows
cash flows that are not all equal in amount year to year
What are the three factors ignored by payback period analysis?
- doesn’t recognize differences in timing of net cash flows w/in payback period
- ignores all cash flows after point in which costs are fully recovered
- ignores time value of money
When accounting rate of return is used to choose between investments, what three factors point to the best investment?
- one with least payback period
- one w/highest return for longest time period
- one w/least risk
What are the limitations of account rate of return analysis?
- bases amount invested on book values, not market values in future periods
- fails to recognize different levels of income variability
- fails to distinguish between two investments w/same average annual net income in early years vs later years
When a company is considering two investment projects, one with even cash flows, the other with uneven, what is the best evaluation method?
net present value
define net present value (NPV)
- dollar estimate of asset’s value that is used to evaluayte acceptability of an investment
- applies time value of money to future cash inflows and outflows to mgmt can evaluate project’s benefits and consts at one point in time
define cost of capital or hurdle rate
- rate company must pay to long-term creditors and shareholders
- company’s required return on the investment
What is the measurement basis for payback period?
cash flows
What is the measurement unit for payback period
years
what are the two strengths of payback period
- easy to understand
2. allos comparison of projects
what is the measurement basis of accounting rate of return?
accrual income
what is the measurement unit of accounting rate of return
percent
what are the two strengths of accounting rate of return
- easy to understand
2. allows comparison of projects
what are the two limitations of accounting rate of return
- ignores time value of money
2. ignores annual rates over life of project
what are the two measurements basis of net present value
- cash flows
2. profitability
what is the measurement unit of net present value
dollars
what are the two strengths of net present value
- reflects time value of money
2. reflects varying risks over project’s life
what is a limitation of net present value
difficult to compare dissimilar projects
what are the two measurement basises for internal rate of return
- cash flows
2. profitability
what is the measurement unit for internal rate of return
percent
what are two strenths of internal rate of return
- reflects time value of money
2. allows comparison of dissimilar projects
what is a limitation of internal rate of return
ignores varying risks over life of project
What is typically teh most popular method for evaluating capital investments?
- internal rate of return
- payback period
- net present value
- few companies use accounting rate of return
what is a profitability index?
- measure of relation between expected benefits of a project and its investment
How do you interpret profitability index?
- higher value indicates more desirable investment, value
2. value below 1 indicates unacceptable project
when is it appropriate to use different discount rates for different projects
when risk levels are different
define internal rate of return
- rate used to evaluate the acceptability of an investment
- this rate will result in a net present value (NPV) of 0 for the investment
- if we compute total present value of project’s net cash flows using IRR as the discount rate, and then subtract inital investment from total present value, result is 0 NPV
break-even time (BET)
- time based measurement used to evaluate the accessibility of an investments
- equal the time expected to pass before the present value of the net cash flows from an investment equals its initial cost
- computed by restating future cash flows in terms of present values and then determining the payback period using these present values
Which cash flow is not considered when using the net present value method?
past cash outflows
Which cash flows are considered when using the net present value method?
- future cash inflows
- future cash outflows
- non-uniform cash inflows
- cash inflow from sale of asset
In business decision-making, managers typically examine the two fundamental factors of:
Risk and rate of return.
what are the four perspectives the balances scorecard requires managers to think of?
- customer (what does customer think of us)
- internal processes: which of our operations are critical to meeting customer needs?
- innovation & learning: how can we improve
- financial: what do our owner sthink of us?
