Chapter 14: Capital Budgeting Decisions Flashcards
What are the two broad categories of capital budgeting
Screening decisions
Preference decisions
What are screening decisions
Does a proposed project meet some preset standard of acceptance
What are preference decisions
Selecting from among several competing courses of action
What do capital budgeting techniques that best recognize the time value of money involve
discounted cash flows
What is the payback period
Length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates
Downfalls of payback method analysis
- does not consider time value of money
- ignores cash flows after payback period
- Shorter payback period does not always mean a more desirable investment
Calculate payback period if the annual net cash inflow is the same each year
Payback period = Investment required / Annual net cash inflow
Strengths of Payback Method
- Serves as screening tool
- Identifies investments that recoup cash investments quickly
3, Identifies products that recoup initial investment quickly
What is the net present value method
compares the present value of a project’s cash inflows with the present value of its cash outflows. The difference between the inflows and outflows is called the net present value
When do cash flows occur
All cash flows other than the initial investment occur at the end of periods
What do positive and negative net present values mean
positive - the return exceeds the discount rate (ACCEPTABLE)
negative - return is less than the discount rate (REJECT)
Zero - return equals required rate of return (ACCEPT)
What is cost of capital
the average return the company must pay to its long-term creditors and stockholders and is usually regarded as the minimum required rate of return
Does the net present value method automatically provide for return of original investment
True, Yes
What is internal rate of return
the rate of return promised by an investment project over its useful life
If the IRR is equal or grater than the minimum required rate of return then
the project is acceptable
If the IRR is less than the minimum required rate of return then
the project is rejected
When using IRR, the cost of capital acts as what
a HURDLE RATE that a project must clear for acceptance
Is NPV or IRR simpler to use and why
NPV because IRR assumes cash inflows are reinvested at the IRR but if IRR is high then this assumption is realistic and its more likely to be reinvested at the discount rate
What alternative should be chosen in decisions where revenues are not directly involved
the alternative with the least total cost from a present value perspective
What are screening decisions
decisions that pertain to whether or not a proposed investment is acceptable; first-priority decisions
What are preference decisions
decisions that attempt to rank acceptable alternatives from the most to least appealing
When using the IRR method to rank, the preference rule is:
The higher the IRR, the more desirable a project
When using NPV method to rank
The NPV cannot be directly compared unless the investments are equal
Ranking investment projects using project profitability index
NPV of project / investment required
What is the simple rate of return
does not focus on cash flows - focuses on accounting net operating income
Calculate Simple rate of return (SRR)
Annual incremental net operating income / (initial investment - salvage value)
Shortcomings of SRR
- Ignores the time value of money
- The same project may appear desirable in some years and undesirable in other years
What is a post-audit
A follow up after the project has been completed to see whether or not expected results were realized
