Strategic Investment Decision (Session 11-12) Flashcards
Capital Budgeting
Capital budgeting is a process
that managers use when they
choose among strategic
investment opportunities
Why is capital budgeting decision important?
Capital budgeting decisions affect
cash flows in future years which
introduces an important concept,
the time value of money, which
refers to the idea that a dollar
received today is worth more
than a dollar received in the
future.
Examples of relevant cash outflows
- Initial investment outlay
- Future operating costs
- Project closing and cleanup costs
Examples of relevant cash inflows include:
- Future revenues
- Decreased operating costs
- Salvage value of assets at project’s end
Methods that consider the time value of money (discounted cash flow methods):
- Net present value (NPV) method
- Internal rate of return (IRR) method
Methods that do not consider the time value of money
- Payback method
- Accrual Accounting rate of return method
Future Value
The amount received in the future, for a given
number of years at a given interest rate, for a
given investment today.
Present value:
The value in today’s dollars of a sum received in
the future.
NPV Method
The NPV of a project is the sum of the project’s discounted cash flows
NPV analysis is often used to…
screen projects as to whether they are
acceptable.
After the screening, acceptable projects may be ranked according to their…
profitability index
Profitability index
Profitability Index = PV of cash inflows / PV of investment cash outflows
The discount rate is…
the interest rate that is used across time to
reduce the value of future dollars to today’s dollars.
Many decision-makers simply…
set the discount rate at the organization’s weighted average cost of capital (WACC)
Internal Rate of Return (IRR) Method
The IRR method determines the discount rate necessary for the present
value of the discounted cash flows to be equal to the investment (solve for
the discount rate at which a project’s NPV equals zero)
The IRR is the…
The IRR is the interest rate (X %) at which:
Initial investment = NPV of cash inflows.
Break-Even Rate of Return
Payback Method
- The payback method computes the number of years before the initial
investment is recovered. - If cash inflows are the same each year and the project has only one initial
outlay, the payback period is computed as
Why is the payback method widely used?
Because of its simplicity
Why is the payback method flawed?
the payback method is flawed because it ignores the time
value of money. It ignores cash flows that occur after the payback period.
What should be done when using the payback method?
If used at all, the payback method should be used in conjunction with
the NPV or IRR methods to help assess project risk.
Accrual Accounting Rate of Return Method
- The accrual accounting rate of return (AARR) is the expected
increase in average annual operating income as a percentage of the
initial increase in required investment.
Why is the AARR widely used?
This method is widely used because financial accounting
information is readily available. It ignores the time value of money.
Qualitative factors often influence strategic investment decisions…
- the effects of the decision on the company’s reputation,
- the effects on the quality of the company’s products and services,
- the effects on the company’s community
- the effects on the environment
- After a capital budgeting decision is made, a post-investment audit should be
performed to assess the decision process.