Capital Budgeting 2 Flashcards
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
Which rate of return is used to re-invest cash flows for Internal Rate of Return?
Cash flows are re-invested at the rate of return earned by the original investment.
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?
When the benefits are greater than the costs.
IRR is greater than the Discount Rate
When is NPV on an Investment Negative?
When Costs are greater than Benefits
IRR is less than the Discount Rate
When is NPV Zero?
When benefits equal the 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.
What is an Expected Return?
An approximate rate of return on assets.
