Week 1 - Introduction To Capital Budgeting Flashcards
What are the two main ways projects are evaluated? And what falls under each category?
Accounting based
- Average Accounting Return
Cash flow based
- Payback period
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Profitability Index (PI)
What is Net Present Value (NPV)? And what is the investment rule regarding NPV?
Net present value is the sum of cash flows discounted at a given rate.
Invest if NPV is greater than 0
Abandon if NPV is less than 0
What is the ‘Cost of Capital’?
The money an investor/firm requires in return for investing in a capital budgeting project such as building a new factory
What is the ‘Internal Rate of Return’ (IRR)?
A measure of the annual rate of return given as a percentage for each year of the project
What is the ‘stand alone principle’?
The principle that focuses on the projects RESULTING incremental cash flows ONLY.
It does not take into account cash flows that would exist without the project
What is the ‘rule’ in capital Budgeting?
If our decision doesn’t affect cash flow, then the cash flow should not affect our decision
What are the three steps to evaluating a proposed project?
1) Get a set of Pro-forma financial statements.
2) Compute future cash flows from the figures on the pro-forma.
3) Evaluate the project using the ‘Decision rules’. (NPV, IRR, PI).
Three things to look out for when appraising a project
- Incidental effects. (Cannibalisation/Erosion).
- Opportunity costs.
- Allocated costs (Costs incurred but not directly related to the project)
What is ‘Net Working Capital’ (NWC)?And What is the equation for Net Working Capital (NWC)?
Net working capital is the money left in a business after Current liabilities and Current Assets have been subtracted.
NWC= Current Assets - Current Liabilities = (Cash + Inventory + Receivables - Payables)
What is Free Cash Flow (FCF) and What is the equation for Free Cash Flow (FCF)?
Free Cash Flow (FCF) is the cash flow available to all investors and creditors within a company.
Free Cash Flow (FCF) = Operating cash flow (OCF) - Capital Expenditure - Net Working Capital (NWC)
What is ‘Operating Cash Flow’ (OCF)? And What is the equation for Operating Cash Flow (OCF)?
Operating Cash Flow (OCO) is the cash flow generated by a companies normal business operations
Operating cash flow = Gross Profit - Tax
What is the formula for ‘Working Capital’?
Cash + Inventory+Accounts Recievable - Accounts Payable
