Chapter 21 - Cost

Question 1

Capital Budgeting

Answer 1

what is capital?
- Capital is funds from all sources
Owner’s equity +debt+ preferred stock
What do I want to use my capital on?
- Capital projects are long-term
can be a long lived asset (over 2 years)
can be a project that takes several years to complete
ie real estate investments, building construction

Question 2

Capital budgeting

Answer 2

• different budget procedures than short term operations
• project by project analysis
  (how do I want to spend my limited $$?)
• companies normally use several evaluation methods
  (NPV, internal rate of return, payback most common)

Question 3

Capital budgeting - 6 stages

Answer 3

step 1) indentify the project (how do I achieve my strategic plans?
step 2) search for the right project
step 3) get information - cost, life, ect
step 4) select the project that will be implemented
step 5) finance the project - debt, equity, working capital
step 6) implementation & control - monitor the project

Question 4

Capital budget - Analysis methods

Answer 4

discount cash flow method

• NPR
• IRR

Use whole numbers (no discounting)
- payback
- accrual accounting rate of return (AAROR)
(no cash)

Question 5

NPV

Answer 5

• Assumes all cash received spent today
• Did I generate enough Cash to meet RRR
  (RRR = cost of cap + required rate of return)
• measures all cash flow in or out over the life of the project
• one dollar today is worth more then one dollar in 1, 5, 10 years

Question 6

NPV - Steps

Answer 6

1. list # years of the project horizontally
2. include ALL cash inflows and outflows
3. obtain correct PV factors
   - annuity
   - non-annuity
4. Multiply PV factor by cash flow
5. Total DCF for project (if >0 project meets RRR)

Question 7

IRR

Answer 7

• rate of return when NPV = 0

- project acceptable if IRR > required rate of return (RRR)

Question 8

Sensitivity Analysis

Answer 8

• shows how changes in key factors affect the project’s return
• sensitivity is important to do because all projects are uncertain
  (small changes can be very important)

Question 9

Payback method

Answer 9

• how many years will it take to get my cash investment back?
• no discounting
• good for short projects
• shorter payback = less risk

Question 10

AAROR

Answer 10

• only measures that uses GAAP accounting
• income is before tax or after tax
• no discounting
• no cash flows

Question 11

Relevant cash flows

Answer 11

• in reality, cash flows include income taxes

- income taxes = pretax GAAP income X tax rate

Question 12

GAAP to Cash

Answer 12

Pretax Cash Flows
- Dep
= Pre tax income
x tax rate
= income taxes
after tax GAAP 
\+ dep expense
= cash flows after tax