Module 7 : Capital Budgeting Flashcards
How much Stages of Capital Budgeting?
5
5 stages of capital Budgeting
- Identify Projects
- Obtain Information
- Make Predictions
- Make Decisions by Choosing Among Alternatives
- Implement the Decision, Evaluate Performance, and Learn
Identify Projects
identify potential capital investments that agree with the organization’s strategy
Obtain Information
gather information from all parts of the value chain to evaluate alternative projects
Make Predictions
Forecast all potential cash flows attributable to the alternative projects
Make Decisions by Choosing Among Alternatives
Determine which investment yields the greatest benefit and the least cost to the organization
Implement the Decision, Evaluate Performance, and Learn
Obtain funding and make the investment selected in stage 4
Track realized cashflows, compare against estimated
numbers, and revise plans if necessary
Methods of Capital Budgeting
- Net Present Value Method (NPV)
-Internal Rate of Return Method (IRR)
-Payback Method - Accrual Accounting Rate of Return Method (AARR)
Net Present Value Method (NPV)
calculates the expected
profit or loss of a project by discounting all expected
future cash flows (DCF) to the present (𝑡_0)
The discount rate used is… (in net present value method)
Required Rate of
Return (RRR)
Required Rate of
Return (RRR)
corresponds to the
minimum return with which an investor wants to be compensated for assuming the risks of a project
Only projects with a
positive NPV or NPV = 0 are…
acceptable
The internal rate (IRR) of return method corresponds to..
the discount rate at which the present value of all cash flows from a specific project is zero. In other words, the IRR is the discount rate at which the NPV = 0.
The internal rate of return is based on which formula ?
the same formula as the NP
A project is only acceptable if IRR is ?
east equal to the RRR
Payback Method
calculates the time needed for a project or investment to recover the (start-up) losses
short payback period
Managers usually prefer
The amortization method is aimed at
liquidity
Accrual Accounting Rate of Return Method (AARR)
divides the average annual return of a project by the initial investment
The AARR method is similar to which other method ?
IRR method, as both methods calculate a percentage value as return
The discounted cash flow (DCF)
calculates all expected future cash flows (inflows and outflows) of a project discounted to the present date
NPV : calculation formula
NPV = -I0 + CF/(1+r)^1 + CF2/(1 +r)^2 + CFn/(1 +r)^n
Why Manager use the IRR method ?
for investement decision
IRR method : calculation
use the NPV caculation but here find r
Application IRR
- use any interest rate and calculate the NPV
- Goal : Interest rate for NPV = 0
- If the NPV is < 0, use a lower interest
- If the NPV > 0, use a higher interest
Payback Method calculation
Payback period =
(Initial Investment / Cashflow p.a.) + period
Accrual Accounting Rate of Return Method (AARR): calculation
Expected net income / initial investement
Expected net income
Average in the future periods, usually after tax and depreciation
Strategic Considerations in Capital Budgeting
- For project evaluation and strategic decisions about which customers to invest in, the presented 5-step framework can be used
- Often R&D projects are judged as important strategic investments; however, the distant payoffs from R&D investments are more uncertain than other investments
- For any strategic capital budgeting decision good judgement and intuition is useful to make a good decision
