Chapter 18 Flashcards
Annual rate of return method definition
The determination of the profitability of a capital expenditure, computed by dividing the expected annual net income by the average investment
Capital budgeting definition
The process of making capital expenditure decisions in business
Cash payback technique definition
A capital budgeting technique that identifies the time period required to recover the cost of a capital investment from the net annual cash flow produced by the investment
Cost of capital definition
The weighted average rate of return that the firm must pay to obtain funds from creditors and stockholders
Discounted cash flow technique
A capital budgeting technique that considers both the estimated net cash flows from the investment and the time value of money
Name the two methods of evaluating capital projects
- Discounted methods
- Non-discounted methods
Name the 2 Discounted methods
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
Name the 2 Non-Discounted Methods
- Cash payback period
- Annual Rate of Return (ARR)
Discount rate definition
The interest rate used in discounting the future net cash flows to determine present value
Return on Asset (ROA)
Net income/ Average Assets
Decision Rule for NPV
Move forward if NPV is equal to or greater than zero
Decision Rule for IRR
Move forward if IRR is equal to or greater than the opportunity cost of capital
Decision Rule for Cash Payback
Move forward if cash payback is equal to or less than acceptable period
Decision Rule for Annual Rate of Return
Move forward if ARR is equal to or greater than the hurdle rate of return
If you have a choice between two positive NPVs
Choose the one with the higher Profitability Index
Formula for Profitability Index
PVI / PVO
Why do we prefer cash flows
(Slide 4)
Name 4 Cash Outflows
- Initial investment
- Repaird and maintencance
- Increased operating costs
- Overhaul of equipment
Name 4 Cash Inflows
(Slide 5)
Why do we discount?
- Time value of money
- Uncertainty of future cash flows
- Effect
What does a higher discount rate imply
Greater uncertainty meaning the present value of the…. (Slide 6)
Shorter the pay back period then the ____ the investment
Better
True/False- Cash payback method ignores discounting
True
Net Present Value Formula
Present value of net cash flows - Capital Investment
