Revised 2 - Capital Budgeting NPV, IRR Flashcards
What is Capital Budgeting? How is it used?
Managerial Accounting technique used to evaluate different investment options Helps management make decisions Uses both accounting and non-accounting information Internal focus GAAP is not mandatory
What values are used in Capital Budgeting?
Capital Budgeting ONLY uses Present Value tables.
Capital Budgeting NEVER uses Fair Value.
How is NPV used to calculate future benefit?
NPV : PV Future Cash Flows - Investment
If NPV is Negative- Cost is greater than benefits (bad investment)
If NPV is Positive- Cost is less than benefit (good investment)
If NPV : 0- Cost : Benefit (Management is indifferent)
How do Salvage Value and Depreciation affect Net Present Value?
NPV includes Salvage Value because it is a future cash inflow.
NPV does NOT include depreciation because it is non-cash.
Exception - If a CPA Exam question says to include tax considerations- then you have to include depreciation because of income tax savings generated by depreciation.
If multiple potential rates of return are available- which is used to calculate Net Present Value?
The minimum rate of return is used.
What is the Internal Rate of Return (IRR)?
It calculates a project’s actual rate of return through the project’s expected cash flows.
IRR is the rate of return required for PV of future cash flows to EQUAL the investment.
Investment / After Tax Annual Cash Inflow : PV Factor
How does the rate used for Internal Rate of Return (IRR) compare to that used for Net Present Value (NPV)?
Rate of return for IRR is the rate earned by the investment. Rate of return for NPV is the minimum rate.
What are the strengths and weaknesses of the Internal Rate of Return system?
Strengths: Uses Time Value of Money- Cash Flow emphasis Weakness: Uneven cash flows lead to varied IRR
When is NPV on an Investment Positive? Negative? =?
When the benefits > costs; IRR > Discount Rate
When the benefits < costs; IRR < Discount Rate
When the benefits = costs; IRR = Discount Rate
What is the Payback Method? How is it calculated?
It measures an investment in terms of how long it takes to recoup the initial investment via Annual Cash Inflow
Investment / Annual Cash Inflow : Payback Method
Compare to a targeted timeframe; if payback is shorter than target- it’s a good investment. If payback is longer than target- it’s a bad investment.
What are the strengths of the Payback Method?
Takes risk into consideration; 2 year payback is less risky than a 5 year payback
What are the weaknesses of the payback method?
Ignores the Time Value of Money Exception: Discount payback method Ignores cash flow after the initial investment is paid back
What is the Accounting Rate of Return?
An approximate rate of return on assets
ARR : Net Income / Average Investment
Compare to a targeted return rate; if ARR greater than target- good investment. If ARR less than target- bad investment.
What are the strengths of the Accounting Rate of Return (ARR)?
Simple to use; People understand easily
What are the weaknesses of the Accounting Rate of Return (ARR)?
Can be skewed based on Depreciation method that is used. Ignores the Time Value of Money.
