Topic 7 - Capital Budgeting Flashcards
What is an independent investment project?
One that stands alone and can be undertaken without influencing the acceptance or rejection of another project? e.g. an investment in a new sales line.
What is a mutually exclusive project?
A project that prevents another from being accepted. e.g replacement of one accounting system, given two options. Selection of one option will exclude the other.
Why is the NPV considered to be the best method for capital budgeting?
Net present value (NPV) of an investment is an estimate of the impact of the investment opportunity on the value of the firm.
It is the best method because It focuses on cash as the driver of value, it takes into account all relevant cash flows, it allows for the time value of money and
it allows for the risk of a project.
What does an NPV tell you?
It quantifies in dollar terms in the increase in the value of the firm and the wealth of shareholders as a result of an investment decision.
Name three types of capital investment projects?
revenue enhancing projects
cost-reduction projects
mandated investment projects.
What does the net relate to in Net Present Value?
The subtraction of the initial outlay of the investment
what does the profitability index (PI) give?
The profitability index provides a relative measure of a proposed investment’s desirability.
The PI is the ratio of the present value of the future net cash flows to the initial outlay (the benefit-cost ratio), and thus, is a number without any associated units of measure - eg it is unknown how much cash it adds.
How is the profitability index useful?
It is useful in ranking or comparison of investments. the NPV and PI give the same accept-reject decision for a given project.
What is the internal rate of return?
It is the rate of return that a project earns given the cash flow produced by the project.
The IRR is the discount rate that equates the present value of the project’s future net cash flows with the project’s initial cash outlay.
What is a payback period?
The number of years needed to recover the initial cash
outlay
What are limitations of the payback period?
Its cut-off standards are subjective, e.g. why is three years to payback necessarily better than four years?
It does not consider the time value of money (TVM).
It does not consider any required rate of return (cost of capital).
It does not consider all of the project’s cash flows, only considering those within the
payback period.
What principles suggest that discounted-cash-flow criteria are the most appropriate to use for capital budgeting?
Discounted Cash-Flow (DCF) criteria are consistent with the principles of measuring a project’s benefits and costs in cash flows in the present to consider the time value of money.
DCF is consistent with the goal of the financial manager, to maximise shareholder wealth.
Selecting projects by DCF methods is generally consistent with the goal of maximising shareholder wealth, particularly in the case of the NPV criterion (wherein NPV is an estimate of the addition to wealth that will occur if the project is selected).
DCF methods also may be adapted to incorporate an allowance for risk, either by adjusting the cash flows or by using a higher discount rate (required rate of return) when evaluating riskier projects.
Why do we focus on cash flows rather than accounting profits in making our capital budgeting decisions?
Cash flows measure the costs and benefits of a project in common units that are meaningful and are sensitive to the time value of money principle (a dollar today is worth more than a dollar in the future).
In contrast, accounting profits do not properly represent the incidence of a project’s benefits and costs, as the recognition of accounting revenues
and expenses does not necessarily coincide with actual cash flows.
What are the advantages of the payback period method?
Deals with cash flows rather than accounting profits and therefore focuses on the project’s true benefits and costs
Is easy to calculate and understand
Can be used as a rough screening device, eliminating projects whose returns do not materialise until later years which represent higher risk.
Does the discounted payback method overcome the problems associated with the traditional payback method?
The discounted payback method is slightly better than the traditional method as it takes into consideration the time value of money.
However, it does not overcome all the shortcomings of the traditional payback method as it still gives no consideration to cash flows that occur after the cut-off date and uses an arbitrary maximum acceptable
discounted payback period.
