Chapter 19: Capital budgeting

Question 1

Discount rate

Answer 1

Measures how much more a dollar is worth today than a dollar one year from now.

Question 2

Payback period

Answer 2

Measures the time required to recoup the initial investment in the capital asset

If cash inflows are constant year to year:
Payback period= initial investment / annual cash flow ( ignores time value of money)

Question 3

Net present value

Answer 3

What the project is worth in today’s values, sum of the present value or all current and future cash inflows and outflows

= (Annual cash inflow x present value factor) - initial outlay

Find present value factor using number of periods and discount rate as interest rate

Results in an absolute measure and favors large projects.

Assumes free cash flows reinvested at discount rate

Question 4

Internal rate of return

Answer 4

Aka IRR

Discount rate computed such that net present value of a project is $0

Set NPV to 0 and solve for present value factor. Then look for that PVF in the annuity table to find the corresponding rate of return

Provides a measure independent of the size of the project (but strict adherence to an IRR average can be damaging)

Again assumes free cash flow reinvested at IRR rate

Question 5

Cost of capital

Answer 5

Weighted average of the company’s cost of debt and its cost of equity

Debt: interest rates on borrowing
Equity: more difficult

If cash available opportunity cost of failing to invest usually lower than opportunity cost of borrowing

Question 6

Hurdle rate

Answer 6

Communicates to managers the appropriate discount rate for investment decisions. Often exceeds cost of capital to encourage conservatism

Question 7

Accounting Rate of Return

Answer 7

ARR
Also: book rate of return

= Average incremental annual income from the project / average net book investment in the project (average over life of asset)

Depends on accounting choices: depreciation method

Incremental annual income = income less depreciation expense

Question 8

Average net book investment

Answer 8

Average of annual book value divided by life of asset + 1 (since year 0 at full value must be considered)

If straight line depreciation is used can simply do (until book value + ending value)/ 2

Any salvage value will increase this number

Question 9

Depreciation tax agield

Answer 9

Reduction in taxes generated by depreciation expense