Chapter 13: Lecture Notes Flashcards
What is Capital Budgeting?
Capital budgeting is the process of evaluating and selecting long-term investments that align with the strategic goals of a business.
It involves estimating expected cash flows, costs, and risks of various projects and choosing those that maximize the firm’s value.
What are examples of capital budgeting decisions?
Examples include purchasing a new printing press, building a new warehouse, opening a second location, or updating an airline fleet.
What are the classifications of capital projects?
Replacement Projects
Expansion Projects
Independent projects
Mutually exclusive projects
What is an independent project?
Independent projects are those whose cash flows are not affected by other projects.
What is a mutually exclusive project?
Mutually exclusive projects are a set of projects where the acceptance of one project means the rejection of the others.
What should an ideal capital project evaluation method include?
All cash flows during the project’s life.
Consideration of the time value of money.
Incorporation of the minimum attractive rate of return (MARR) or required rate of return on the project.
What is the Payback Period (PP)?
The payback period is the number of years required to fully recover the initial cash outlay associated with a capital expenditure.
How is the Payback Period (PP) calculated?
PP = T
T = the length of time required to recover the initial investment
CF_0 = initial cash outlay
CF_t = cash flow at time t
What is the decision rule for Payback Period (PP)?
If calculated PP T is lower than or equal to the target or maximum acceptable payback period T, accept the project.
If T is greater than T, reject the project.
What is the Net Present Value (NPV)?
NPV is the sum of the present value of all future after-tax incremental cash flows generated by an initial cash outlay, minus the present value of the investment outlays.
How is NPV calculated?
NPV = ∑(t=1 to n) [ (CF_t) / (1+k)^t ] - CF_0
where
CF_t = cash flow at time t
k = discount rate
CF_0 = initial cash outlay
What is the decision rule for Net Present Value (NPV)?
Accept the project if NPV is positive, as it adds value to the firm. Reject if NPV is negative.
What is the Internal Rate of Return (IRR)?
IRR is the discount rate that causes the NPV of a project to equal zero, representing the project’s rate of return.
What is the decision rule for Internal Rate of Return (IRR)?
Accept the project if IRR > WACC.
Reject if IRR < WACC.
What are the key differences between NPV and IRR?
NPV measures the estimated increase in the firm’s value in absolute terms and assumes reinvestment at WACC.
IRR estimates the project’s rate of return and assumes reinvestment at the IRR.
