Financial Mgmt - Capital Budgeting

Question 1

Payback Period Approach

Answer 1

The payback period is computed by dividing the initial investment by the annual net cash inflow.

Depreciation expense is not subtracted from cash inflow; only the income taxes that are affected by the depreciation deduction are subtracted

One of the weaknesses of the payback period is that it does not use the time value of money.

The payback method evaluates investments on the basis of the length of time until the initial investment is returned. If annual cash flows are constant, the payback period is calculated as follows:

Initial investment

Annual cash flow

Question 2

Accounting Rate of Return

Answer 2

The Accounting Rate of Return (also called the Simple Rate of Return) Method: Assesses a project by measuring the expected annual incremental accounting income from the project as a percentage of the initial (or average) investment

Expressed as a formula

ARR = (Average annual incremental revenues − Average annual incremental expenses) / Initial (or Average) investment

Accounting return is often used as a performance evaluation measure. Therefore, if it is also used as an evaluation technique, the consistency may lead to better decisions.

Question 3

Internal Rate of Return

Answer 3

The internal rate of return is the time-adjusted rate of return from an investment.

Question 4

Net Present Value

Answer 4

The net present value method is considered the best method in terms of considering profitability of the project.

Question 5

Payback Period Approach

Answer 5

The payback method simply determines when the initial investment is recovered on an undiscounted basis.

The payback period approach to assessing a capital project determines the number of years (or other periods) needed to recover the initial cash investment in the project and compares the resulting time with a pre‐established maximum payback period.

If the expected payback period for a project is equal to or less than the pre‐established maximum, the project is deemed acceptable; otherwise, it would be considered unacceptable

The payback period computes the number of periods until the investment cost is recovered and ignores cash flows after that point.

Question 6

Discounted Payback Period Method

Answer 6

• The discounted payback period method is a variation of the payback period approach, which takes the time value of money into account.
• It does so by discounting the expected future cash flows to their present value and uses the present values to determine the length of time required to recover the initial investment.
• Because the present value of the cash flows will be less than their future (nominal) values, the discounted payback period will be longer than the undiscounted payback period

Question 7

Time Value of Money

Answer 7

There are two capital budgeting methods which consider time value of money:

internal rate of return

and

net present value.

Under the net present value method, all cash inflows and outflows related to a capital project are discounted to a present value and netted to arrive at a net present value for the project. In order to discount the inflows and outflows, a discount rate must be determined in advance of the analysis of the project.

Question 8

Net Present Value

Answer 8

Net present value modeling takes into account the compounding of returns (the time value of money).

Question 9

Risk / Return Relationship

Answer 9

• There is a direct (positive) relationship between risk and return. Higher returns are associated with higher degrees of risk.
• An inverse relationship would imply that higher returns are associated with less risk.

Question 10

Covariance

Answer 10

• Covariance is a measure of how the price of one asset moved in relation to the movement of another (or other) assets.
• A positive covariance means that the price of assets most often move in the same direction.
• Negative covariance means the price of assets generally move in opposite directions.
• Since the determination of the variance of a portfolio is determined by the variance of the separate assets in the portfolio, the extent to which the asset prices move in the same direction or opposite direction affect the variance of the entire portfolio.

Question 11

Portfolio Variance

Answer 11

The variance of a portfolio (set of stocks) is a measure of the variation or fluctuation of the returns on that portfolio over time.

The expected market rate (of interest) plays no role in the historic value of an asset and, therefore, does not affect the variance of a portfolio (set) of assets.

Question 12

Internal Rate of Return

Answer 12

The internal rate of return method determines the rate of return at which the present value of the cash flows or benefits will exactly equal the investment outlay.

This method assumes that cash flows received are reinvested to earn the same internal rate of return.

The net present value method requires the selection of a discount rate which represents the minimum rate of return desired.

IRR assumes that all cash flows received are reinvested at this minimum rate of return and not at the rate earned on the investment.