Ch 21 Flashcards
5 stages of capital budgeting process?
1 identify projects 2 obtain info 3 make predictions 4 make decision among alternatives 5 implement the decision, evaluate the performance and Learn
Capital budgeting
Process of making long-run planning decisions for
Investments in projects
Capital budgeting stage 1: identify projects
Identify potential capital investments that agree with
The organization’s strategy
Capital budgeting stage 2: obtain information?
Gather info from all parts of value chain to evaluate
Alternative projects
Capital budgeting stage 3: make predictions
Forecast all potential cash flows attributable to
Alternative projects
Capital budgeting stage 4: make decisions by choosing among alternatives
Determine which investment yields the greatest benefit
And the least cost to the organization
Capital budgeting stage 5: implement the decision, evaluate performance, and learn. 2 phases?
Obtain funding and make investments selected stage 4
Track realized cash flows, compare against estimated
numbers and revise plans if necessary
4 capital budgeting methods used to analyze financial info?
1 net present value (NPV)
2 Internal rate of return (IRR)
3 payback
4 Accrual accounting rate of return (AARR)
2 discounted cash flow methods?
1 net present value NPV
2 internal rate of return IRR
Discounted cash flow methods, define
Measure all expected future cash inflows and outflows
Of project discounted back to present point in time
Time value of money
Dollar received today is worth more than dollar received
At any future time
Required rate of return AKA discount rate, hurdle rate, cost of capital or opportunity cost
Minimum acceptable annual rate of return on an
investment
Net present value (NPV) method Calculates expected monetary gain or loss from project by…
discounting all expected future cash inflows + outflows
Back to present point in time using required rate of return
3 steps to use the net present value (NPV) method?
1 draw sketch of relevant cash inflows and outflows
2 discount cash flows using the correct compound
Interest tables and sum them
3 make project decision on calculated NPV
Internal rate of return (IRR) calculates…
discounted rate where investment’s present value (PV)
of all expected cash inflows = PV of expected cash outflows
Payback method
Measures time it takes to recoup, in form of expected
Future cash flows, net initial investment of project
Uniform cash flows: payback period equation?
Payback period =
net initial investment/uniform increase in annual future cash flows
3 conditions that make payback method a useful measure?
1 preliminary screening of many proposals is necessary
2 interest rates are high
3 expected cash flows in later years of projects are
Uncertain
2 weaknesses of payback period?
Doesn’t consider time value of money
Doesn’t consider cash flows after payback period
Discounted payback method
Calculates amount of time required for present value of
Cash inflows to equal PV of outflows
accrual accounting rate of return (AARR) method
Divides avg. annual (accrual accounting) income of project
By measure of investment in it
Accrual accounting rate of return equation?
Accrual accounting rate of return =
Increase in expected avg. annual after tax income/
Net initial investment
3 categories of cash flows in capital investment project?
1 net initial investment in project
2 after tax cash flow from operations
3 after tax cash flow from disposal of asset and recovery
Of working capital
What does that net initial investment in a project include?
(Acquisition of assets) + (associated additions to working
capital) - (after tax cash flow from disposable existing asset)
What does after tax cash flow from operations include?
Income tax cash savings from annual depreciation
Deductions
What does the discounted payback method adjust for?
The time value of money
What does the discounted payback method overlook?
Cash flows after discount payback period
What is the strength of accrual accounting rate of return AARR?
Gives managers an idea of effect of accepting project
On their future reported accounting profitability
What are the 2 main weaknesses of AARR accrual accounting rate of return?
1 Does not track cash flows
2 ignores time value of money
What are the relevant cash inflows and outflows for DCF analysis for capital budgeting decisions?
Differences in in expected future cash flows as result
Of making investment
How should accrual accounting concepts be considered in DCF capital budgeting decisions?
Are irrelevant to DCF methods
What conflict can arise btw using DCF methods for capital budgeting decisions and accrual accounting for capital budgeting decisions?
Decisions made to use DCF will not report good
“operating income” in project’s early years under
accrual accounting
How can you reduce the conflict of using DCF methods for capital budgeting decisions and accrual accounting for performance evaluation?
Evaluate managers on project by project basis
To see if they can achieve the amounts and timing of
Forecasted cashflows
Inflation
Decline in general purchasing power of monetary unit
Real rate of return
Rate of return demanded to cover investment risk if there
Is no inflation
Nominal rate of return
Rate of return demanded to cover investment risk
And decline in general purchasing power of monetary
Unit resulting from expected inflation
Identify and define 2 elements that compose the real rate of return?
1 risk free element, pure rate return on risk free investment
2 business risk element, risk premium demanded for
Bearing risk
3 elements that make up the nominal rate of return?
1 risk free element
2 business risk element
3 inflation element
Net present value internal consistency: nominal approach
Predicts cash inflows and outflows in nominal monetary
Units
and uses nominal rate as required rate of return
Net present value internal consistency: real approach
Predicts cash inflows and outflows in real monetary units
And uses a real rate as required rate of return
