Chapter 13 notes Flashcards
Describe the capital budgeting process
usually companies follow a carefully prescrivbed process
because capital budgeting decisions are VERY important
What does the capital budgeting process involve
involves top management and the board of directors
What is important about the capital budget
the decisions often have a significant impact on a compay’s future profitability
- poor capital budgeting decisions can cost the company a lot of money
What is done at least once a year in capital budgeting
- project proposals are requested from departments, plants and authorized personnel
- proposals are examined by capital budget committee
- officers determine which projects are worthy of funding
- the board of directors approves the capital budget
Capital budgeting decsions depend on a variety of considerations. What are they
- availability of funds
- relationships among proposed projects
- company’s basic decision making approach
- risk associated with the particular project
Regarding budgeting what is cash flow information
for the purposes of capital budgeting, estimated cash inflows and outflows are the preferred inputs
What are some typical cash outflows
- initial investment
- repairs and maintenance
- increased operating costs
- overhaul of equipment
what are some typical cash inflows
- sale of old equipment
- increased cash received from customers
- reduced cash out flow from operating costs
- salvage value of old equipment when project is complete
What are the several methods that can help companies make effective capital budgeting decisions
- cash payback technique
- the net present value method
- the internal rate of return method
- annual rate of return method
What do most of the capital budgeting methods uses
most of them use cash flow numbers rather than accrual accounting revenues and expenses
Describe the cash payback method
- identifies the time period required to recover the cost of the capital investment from the annual cash inflow produced by the investment
What determines the attractiveness of an investment in the cash payback method
the shorter the payback period, the more attractive the investment
True for 2 reasons:
- the earlier the investment is recovered, the sooner the cash can be used for other purposes
- the risk of loss from obsolescence and change economic conditions is less in a shorter payback period
what is the cash payback formula
cost of capital investment / net annual cash flow (inflows - outflows) = cash payback period
describe the net present value method
- generally recognized as the best conceptual approach to making capital budgeting decisions
- considers both the estimated total cash inflows and the time value of money
What are two methods used with the discounted cash flow technique
- net present value
2. internal rate of return
What is the formula for Net Present value
present value of net cash flows - capital investment = net present value
Net present values: in choosing discount rate a company usually sues what ?
a discount rate that is equal to its cost of capital (rate it must pay to obtain funds from creditors and shareholders)
Net PRsent Value: cost of capital is what
the weighted average of the rates paid on borrowed funds as well as on funds that are provided by investors in the company’s common and preferred shares
Net Present Value: if a project is believed to be of higher risk than the company’s usual line of business what happens to the discount rate
it is increased
what are some other names for the discount rate
- Hurdle -rate
- Required rate of return
- cut-off rate
What are the simplifying assumptions in Net present value method
- all cash flows come at the end of the year
- all cash flows are immediately reinvested in another project that has a similar return
- all cash flows can be predicted with certainty
In reality what are the assumptions for Net present value method
project results are only estimates
- based on forecasters belief about what is most likely to happen
What is the one approach for dealing with uncertainty in the net present value method
Sensitivity analysis
describe the sensitivity analysis
uses several outcome estimates to get a sense of the variability among potential returns
Net Present Value: What are two approach that suggested to avoid rejecting projects that actually should be accepted
- calculate net present value ignoring intangible benefits
- project rough, conservative estimates of the value of the intangible benefits
- and incorporate these values into the NPV Calculation
describe calculate the net present value ignoring intangible benefits
if the NPV is negative, ask
whether the intangible benefits are worth at least the amount of negative NPV
The Net Present Value: Profitability Index
what is it
considers both the size of the original investment and the discounted cash flows
What is the formula for profitability index
present value of net cash flows / initial investment = profitability index
Post Audition of investment projects
why is it important
- if managers know that their estimates will be compared to actual results
- managers will be more likely to submit reasonable and accurate data
- provides a formal mechanism to determine whether existing projects should be supported or terminated
- improve future investment proposals by evaluating past successes and failures, managers improve their estimation techniques
What is the internal rate of return method
finds the interest yield of the potential investment
- this is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows
Which two methods are most widely used
- internal rate of return
2. cash payback method
Internal rate of return: how do you determine the true interest rate
step 1: calculate the internal rate of return factor (capital investment / annual cash inflows = internal rate of return factor)
Step 2: use the factor and the present value of an annuity of table to find the internal rate of return
how do you find the internal rate of return on a table
locate the discount factor that is closest to the internal rate of return factor for the time period covered by the annual cash flows
How does net present value calculate a dollar amount or percentage
dollar amount
how dose internal rate of return calculate a dollar amount or percentage
percentage
what is the decision rule in net present value
if the net present value is zero or positive, accept the proposal.
- if it is negative, reject it
what is the decision rule internal rate of return
if the internal rate of return is equal to or greater than the required rate of return - accept
What is the annual rate of return technique
based on accounting data
- indicates the profitability of a capital expenditure
- compared with its required minimum rate of return for investments of similar risk
What is the minimum rate of return based on
company’s cost of capital
- which is the rate of return that management expects to pay on all borrowed and equity funds
What is the formula for annual rate of return
expected net income / annual average investment = annual rate of return
what is the formula for computing the annual average investment
expected annual net income is obtained from the projected income statement
formula: original investment + value at tend of useful life / 2
What is the decision rule for the annual rate of return technique
project is acceptable if its rate of return is greater than management’s minimum rate of return
when choosing among several acceptable projects,
- the higher the rate of return for a given risk, the more attractive the investment
