Reading #36 - Capital Budgeting Flashcards
describe capital budgeting process
identifies and evaluates capital projects, where cash flow to firm will be rec’d over a period longer than a year
what are the four steps in capital budgeting?
- idea generation 2. analyzing project proposals 3. create firm wide capital budget 4. monitoring decision post audit
Describes types of capital budgeting projects
- replacement to maintain business or for cost reduction 2. expansion 3. new product 4. mandatory projects for gov’t 6. others like R&D
Describe the 5 KEY principals of capital budgeting
- “decision based on cash flows, not accounting income” 2. “cash flows based on opp costs” 3. timing of cash flows is import. 4.”cash flows are analyzed on after tax” 5. financing costs reflected in projects IRR”
what is sun cost?
cost cannot be avoided even if project is not undertaken
define externalities
“effects acceptance of project may have on other firm cash flows” example is cannibalization
define cannibalization
when new project reduces sales of existing product
define opportunity cost
“cash flows that firm will lose by undertaking project under analysis”
Define the payback period
number of years it takes to recover the initial cost of an investment
drawback to payback period
does not take into account TVM or cash flows beyond payback period - so no terminal or salvo value considered
can a project have multiple IRRs?
yes - if cash flows are unconventional, there may be multpe IRRs that provide an NPV = 0
can a project have no IRR?
yes and still be profitable. Unconventional cash flows where mathematically, no IRR exists
When does a firm exhibit capital rationing?
“when a company has a fixed (maximum) amount of funds to invest. If profitable project opportunities exceed the amount of funds available, the firm must ration, or prioritize its funds to achieve the maximum value for shareholders given its capital limitations.”
