Ch21

Question 1

Four Methods of Capital Budgeting Analysis

Which methods consider accrual accounting income

Which methods consider net cash inflow

Answer 1

1. Payback period
2. Rate of return (ROR)
3. Net present value (NPV)
4. Internal rate of return (IRR)

Only ROR considers income, all others consider net cash flow

Question 2

Payback period =

Answer 2

Payback is the length of time it takes to recover, in net cash inflows, the cost of the capital outlay.

Question 3

Rate of return (ROR) =

Answer 3

The ROR focuses on the operating income, not the net cash inflow, an asset generates. The ROR measures the average accounting rate of return over the asset’s entire life.

Rate of Return = Average annual operating income from an asset = %

Average amount invested in an asset

Average annual operating income = ( Total Cash Flow - Total Depreciation ) / Years

Total Depreciation = Initial Investment - Residual Value

Average amount invested = (Initial Investment + Residual Value) / 2

Question 4

Net present value (NPV) =

Answer 4

The NPV is the net difference between the present value of the investment’s net cash inflows and the investment’s cost (cash outflows).

Question 5

Internal rate of return (IRR) is ….

Answer 5

The internal rate of return (IRR) is the rate of return (based on discounted cash flows) a company can expect to earn by investing in a capital asset. It is the interest rate that makes the NPV of the investment equal to zero.