Exam 2 (Quiz 6) - Chapter 26 Flashcards
Answer:
Capital budgeting is making a decision on ___(a)___ and doing this (a) is ___(b)___
a. capital investment
b. acquiring capital assets
Answer:
Capital budgeting affects ___(a)___ and requires ___(b)___
a. operations for many years
b. large sums of money
Examples (list):
Capital Budgeting
- Purchasing new equipment
- Building new facilities
- Automating production
- Developing websites
List:
4 Methods of Analyzing Potential Capital Investments
- Payback Period
- Rate of Return (ROR)
- Net Present Value (NPV)
- Internal Rate of Return
Answer (list):
Which methods of analyzing potential capital contribution are quick and good for investments with a short life?
- Payback Period
2. Rate of Return (ROR)
Answer (list):
Which methods of analyzing potential capital contribution factor the time value of money?
- Net present value (NPV)
2. Internal rate of return (IRR)
Answer:
What does ROR stand for?
Rate of Return
Answer:
What does NPV stand for?
Net Present Value
Answer:
What does IRR stand for?
Internal Rate of Return
Define:
Payback Period
Length of time it takes to recover the cost of the capital outlay
Answer:
The payback period measures ___(a)___. The ___(b)___ the payback period, the ___(c)___
a. how quickly managers expect to recover investment
b. shorter
c. more attractive the asset
Equation:
Payback Period
Amount Invested
/
Expected Annual Net Cash Inflow
Answer:
What does equal annual net cash inflows mean for the payback period?
Return in savings or cash flows are equal from year to year
Answer:
What does unequal annual net cash inflows mean for the payback period?
Total net cash inflows until the amount invested is recovered
List:
Criticisms of the Payback Period Method
- Focuses only on time, not profitability
2. Ignores cash flows after the payback period
Answer:
For the payback period method, the investments with ___(a)___ are more desirable
a. shorter payback periods
Answer:
What does ARR stand for?
Accounting Rate of Return
Define:
Average Annual Operating Income
The asset’s total operating income over the course of its operating life divided by its lifespan
Define:
Average Amount Invested
Net book value at the beginning of the asset’s useful life plus the net book value at the end of the assets life divided by 2
Answer:
According to the decision rule regarding ARR to decide about investing in capital assets, if the ___(a)___, you should invest, and if the ___(b)___ you should not invest
a. Expected rate of return exceeds the required rate of return
b. Expected rate of return is less than the required rate of return
Answer:
Payback and ARR do not recognize ___(a)___
a. time value of money
Answer:
NPV and IRR do recognize ___(a)___
a. time value of money
Define:
Net Present Value (NPV)
The present value of the investment’s net cash flow minus the present value of investment’s cost (cash outflow)
Define:
Discount Rate of NPV
The interest rate that discounts or reduces future amounts to their lesser value in the present
Answer:
If present value of the investment’s net cash inflows ___(a)___ the initial cost of the investment, then it is a good investment
a. exceeds
Answer:
If the investment is expected to bring in even cash flows, use ___(a)___ table
a. Present Value of Annuity
Answer:
If cash flow amounts are unequal, ___(a)___ is computed and you use ___(b)___ table
a. present value of each individual cash flow
b. Present Value of $1 (PV)
Answer:
NPV is higher if ___(a)___, if ___(b)___, or if ___(c)___
a. cash inflows are larger
b. they come sooner
c. the discount rate is lower
Answer:
Using NPV method, the present value factor is selected using ___(a)___ or ___(b)___
a. the company’s required rate of return
b. discount rate
Define:
NPV > 0
The actual rate of return > the required rate of return
However, you do not know the actual rate of return, only that it is greater than the required rate of return
Define:
NPV = 0
actual rate of return = required rate of return
Answer:
With the NPV method, the actual rate of return is called the ___(a)___. In other words, the ___(b)___ is the ___(c)___ that makes ___(d)___
a. internal rate of return (IRR)
b. internal rate of return
c. interest rate
d. NPV = 0
Define:
Internal Rate of Return (IRR)
Rate of return a company can expect to earn by investing in the project
Answer:
The internal rate of return is the interest rate that will cause ___(a)___
a. NPV to equal 0
Answer:
The higher the IRR, the better ___(a)___
a. the chance of strong growth
Answer:
The decision rule for IRR says that if ___(a)___ you should invest and if ___(b)___ you should not invest
a. the IRR exceeds the required rate of return
b. the IRR is less than the required rate of return
List:
Steps for Computing IRR of and Investment with EQUAL Periodic Cash Flows
- IRR is the interest rate that makes the cost of the investment = the present value of the investment’s net cash flows
- Plug into the equation any information we do know
- Rearrange the equation and solve for the annuity PV factor (I=?, n=5)
- Find the interest rate that corresponds to this annuity PV factor
Equation:
IRR for Equal Cash Flows
Investment's Cost = Amount of each equal net cash inflow * Ordinary Annuity PV Factor
Answer:
If the IRR exceeds Required Rate of Return (RRR), then the project has ___(a)___ (___(b)___)
a. positive NPV
b. favoring acceptance
Answer:
If IRR equals RRR, ___(a)___, so ___(b)___ and ___(c)___ yield ___(d)___
a. NPV = 0
b. project acceptance
c. rejection
d. the same value
Answer:
If IRR is less than RRR, ___(a)___ (___(b)___)
a. NPV is negative
b. favoring rejection
Answer:
NPV is generally regarded as the ___(a)___ compared to IRR
a. preferred method
Answer:
NPV expresses the computations in ___(a)___, not in ___(b)___
a. dollars
b. percentages
Answer:
NPV method can be used when the discount rate ___(a)___
a. varies over the life of the product
