Reading 32: Capital Budgeting Flashcards
Define discounted payback period and give the advantage and drawback of the calculation.
Equals the number of years it takes for cumulative discounted cash flows from the project to equal the project’s initial investment outlay. A discounted payback period will always be greater than its payback period because the payback period doesn’t discount the cash flows.
Advantage: Accounts for the time value of money and risks associated with the project’s cash flows.
Drawback: Ignores cash flows that occur after the payback period is reached. Therefore, it does not consider the overall profitability of the project.
Identify the decision rules for NPV.
A project should be undertaken if its NPV is greater than zero. Positive NPV projects increase shareholder wealth.
Projects with a negative NPV decrease shareholder wealth and should not be undertaken.
A project with an NPV of zero has no impact on shareholder wealth.
Give the formula used to calculate average accounting rate of return (AAR) and identify the advantage and drawbacks of AAR.
AAR = Average net income / Average book value
Advantage: It is easy to understand and easy to calculate.
Drawbacks:
It is based on accounting numbers and not cash flows. Accounting numbers are more susceptible to manipulation than cash flows.
It does not account for time value of money.
It does not differentiate between profitable and unprofitable investments accurately, as there are no benchmarks for acceptable AARs.
Give the formula used to calculate NPV with one investment outflow.
NPV =n∑t=1
CFt /(1+r)t − Outlay
Where
CFt = after-tax cash flow at time t.
r = required rate of return for the investment. This is the firm’s cost of capital adjusted for the risk inherent in the project.
Outlay = investment cash outflow at t = 0.
Describe the profitability index (PI) of an investment, and explain the decision rules.
It equals the present value (PV) of a project’s future cash flows divided by the initial investment.
Decision Rules
A company should invest in a project if its PI is greater than 1. The PI is greater than 1 when NPV is positive.
A company should not invest in a project if its PI is less than 1. The PI is less than 1 when NPV is negative.
Explain a payback period and identify its advantages and disadvantages.
Equals the time it takes for the initial investment to be recovered through after-tax cash flows
Advantages:
Simple to calculate and explain
Can be used as an indicator of liquidity
A shorter payback period may be more liquid than a longer payback period
Disadvantages:
Ignores the risk of the project
Cash flows aren’t discounted at the required rate of return
Ignores cash flows that occur after payback period is reached
Not a measure of profitability, so can’t be used in isolation to evaluate capital investment projects
Identify the decision rules for IRR.
A company should invest in a project if its IRR is greater than the required rate of return. When the IRR is greater than the required return, NPV is positive.
A company should not invest in a project if its IRR is less than the required rate of return. When the IRR is lower than the required return, NPV is negative.
