5 Flashcards
(36 cards)
Term
Definition
What is capital budgeting?
The process of planning long-term investments, such as purchasing long-term assets.
What are the key investment criteria?
Payback Period, Discounted Payback Period, NPV, PI, IRR.
What is NPV?
Net Present Value: The total present value of cash flows minus initial investment cost.
What is IRR?
Internal Rate of Return: The discount rate that makes the NPV of an investment zero.
What is PI?
Profitability Index: PV of inflows divided by initial outlay, accept if PI > 1.
What is the Payback Period?
Time needed to recover the initial investment from cash inflows.
What are the advantages of Payback Period?
Easy to understand, emphasizes liquidity.
What are the disadvantages of Payback Period?
Ignores time value of money and cash flows after cutoff.
How does Discounted Payback Period differ?
Uses present values of cash flows, accounts for time value.
How is NPV calculated?
NPV = ∑ CFt / (1 + r)^t − CF0
When should a project be accepted using NPV?
When NPV > 0.
What is the formula for PI?
PI = PV of future cash flows / Initial investment
What is the IRR decision rule?
Accept if IRR > required return.
What are the IRR advantages?
Easy to communicate, gives rate of return.
What are the IRR disadvantages?
May not exist or have multiple IRRs, ignores scale of investment.
What is incremental cash flow?
The difference in a firm’s cash flows with and without a project.
Should sunk costs be included?
No, sunk costs are not incremental.
Should opportunity costs be included?
Yes, they represent foregone alternatives.
Should side effects be included?
Yes, if they affect other parts of the business.
What are the three components of cash flow estimation?
a) Capital spending, b) Annual operating cash flows, c) Terminal year cash flows.
What is the formula for OCF using net income?
OCF = Net Income + Depreciation.
What is an alternative OCF formula?
OCF = (Sales − Costs) × (1 − Tax rate) + Depreciation tax shield.
