Capital Budgeting

Question 2

What is Capital Budgeting? How is it used?

Answer 2

Managerial Accounting technique used to evaluate different investment options

Helps management make decisions

Uses both accounting and non-accounting information

Internal focus

GAAP is not mandatory

Question 3

What values are used in Capital Budgeting?

Answer 3

Capital Budgeting ONLY uses Present Value tables.

Capital Budgeting NEVER uses Fair Value.

Question 4

When is the Present Value of $1 table used?

Answer 4

For ONE payment- ONE time.

Question 5

When is the Present Value of an Annuity Due used?

Answer 5

Multiple payments made over time- where the payments are made at the START of the period.

Question 6

When is the Present Value of an Ordinary Annuity of $1 (PVOA) used?

Answer 6

Multiple payments over time- where payments are made at the END of the period.

Think A for Arrears.

Question 7

What is the calculation for the Present Value of $1?

Answer 7

1 / (( 1+i )^n)

i = interest rate
n = number of periods

Question 8

What is Net Present Value (NPV)?

Answer 8

A preferred method of evaluating profitability.

One of two methods that use the Time Value of Money

= PV of Future Cash Flows - Investment

Question 9

What is the rate of return (hurdle/target rate) on an investment called and what is it based on?

Answer 9

The Discount Rate based on the market rate of return for projects with similar risks.

Question 10

What does the Discount Rate represent?

AKA Hurdle or Target Rate

Answer 10

The rate of return on an investment used.

It represents the minimum rate of return required.

It should not be lower than the cost of capital/ because that is the rate at which the company is charged for it’s capital.

Question 11

How is NPV used to calculate future benefit?

Answer 11

NPV = PV Future Cash Flows - Investment

If NPV is Negative- Cost is greater than benefits (bad investment)

If NPV is Positive- Cost is less than benefit (good investment)

If NPV = 0- Cost = Benefit (Management is indifferent)

Question 12

What are the strengths of the Net Present Value system?

Answer 12

Uses the Time Value of Money

Uses all cash flows- not just the cash flows to arrive at Payback

Takes risks into consideration

Question 13

What are the weaknesses of the Net Present Value system?

Answer 13

Not as simple as the Accounting Rate of Return.

Question 14

How do Salvage Value and Depreciation affect Net Present Value?

Answer 14

NPV includes Salvage Value because it is a future cash inflow.

NPV does NOT include depreciation because it is non-cash.

Exception – If a CPA Exam question says to include tax considerations- then you have to include depreciation because of income tax savings generated by depreciation.

Question 15

If multiple potential rates of return are available- which is used to calculate Net Present Value?

Answer 15

The minimum rate of return is used.

Question 16

What is the Internal Rate of Return (IRR)?

Answer 16

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

Question 17

Which rate of return is used to re-invest cash flows for Internal Rate of Return?

Answer 17

Cash flows are re-invested at the rate of return earned by the original investment.

Question 18

How does the rate used for Internal Rate of Return (IRR) compare to that used for Net Present Value (NPV)?

Answer 18

Rate of return for IRR is the rate earned by the investment.

Rate of return for NPV is the minimum rate.

Question 19

What are the strengths and weaknesses of the Internal Rate of Return system?

Answer 19

Strengths: Uses Time Value of Money- Cash Flow emphasis

Weakness: Uneven cash flows lead to varied IRR

Question 20

When is NPV on an Investment positive?

Answer 20

When the benefits are greater than the costs.

IRR is greater than the Discount Rate

Question 21

When is NPV on an Investment Negative?

Answer 21

When Costs are greater than Benefits

IRR is less than the Discount Rate

Question 22

When is NPV Zero?

Answer 22

When benefits equal the Costs

IRR = Discount Rate

Question 23

What is the Payback Method? How is it calculated?

Answer 23

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.

Question 24

What are the strengths of the Payback Method?

Answer 24

Takes risk into consideration

2 year payback is less risky than a 5 year payback

Question 25

What are the weaknesses of the payback method?

Answer 25

Ignores the Time Value of Money

Exception: Discount payback method

Ignores cash flow after the initial investment is paid back

Question 26

What is the Accounting Rate of Return?

Answer 26

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.

Question 27

What are the strengths of the Accounting Rate of Return (ARR)?

Answer 27

Simple to use

People understand easily

Question 28

What are the weaknesses of the Accounting Rate of Return (ARR)?

Answer 28

Can be skewed based on Depreciation method that is used.

Ignores the Time Value of Money.

Question 29

What is an Expected Return?

Answer 29

An approximate rate of return on assets.

Question 30

What are some ways to Analyze Risk/Probabilistic Approaches to determining the strength of NPV calculations?

Answer 30

Sensitivity Analysis - explores the importance of assumptions underlying a forecast.

Scenario Analysis - the effects of changes in a group of related variables - a more complex variation of sensitivity analysis

Simulation Models - software that makes it possible to model the effects of even more economic conditions

Decision Trees - multiple decisions that are involved in implementing a project

Real Options - views an investment as a purchasing option

Question 31

What is the Total Return of an Asset and the assumption of the Gordon Growth Model?

Answer 31

The total return of as investments includes cash dist. (interest & dividends) and the change in value of an asset Total Return = Distribution Rate + Growth Rate.

The Gordon Growth Model assumes that reinvested assets will increase distributions by the amount of the reinvestment and will end up growth in assets = growth in future dividends

Question 32

What is a common way to estimate expected returns based on prior history?

Answer 32

Arithmetic Average (Simple Average) ideal for investments with short holding periods

Geometric Average - the consistent return that would grow to the same final result as actual returns of several different periods (compounding) and better for estimating investments with long holding periods

Question 33

What is the excess present value (profitability) index and how is it calculated?

Answer 33

Computes the ratio of the present value of cash flows to the initial cost of a project.
PV of future net cash flows/Initial Investment * 100

Uses - in determining the NPV (ranking) when there is a limit of funds available

If the index is greater than or equal to 100 it is generating a return higher than the Min. rate of return