Flashcards in Capital Budgeting Deck (28):
Managerial Accounting technique used to evaluate different investment options
Helps management make decisions
Uses both accounting and non-accounting information
GAAP is not mandatory
Capital Budgeting ONLY uses Present Value tables.
Capital Budgeting NEVER uses Fair Value.
For ONE payment- ONE time.
Multiple payments made over time- where the payments are made at the START of the period.
Multiple payments over time- where payments are made at the END of the period.
Think A for Arrears.
1 / (( 1+i )^n)
i : interest rate
n : number of periods
A preferred method of evaluating profitability.
One of two methods that use the Time Value of Money
: PV of Future Cash Flows - Investment
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)
The Discount Rate.
The rate of return on an investment used.
It represents the minimum rate of return required.
Uses the Time Value of Money
Uses all cash flows- not just the cash flows to arrive at Payback
Takes risks into consideration
Not as simple as the Accounting Rate of Return.
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.
The minimum rate of return is used.
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
Cash flows are re-invested at the rate of return earned by the original investment.
Rate of return for IRR is the rate earned by the investment.
Rate of return for NPV is the minimum rate.
Strengths: Uses Time Value of Money- Cash Flow emphasis
Weakness: Uneven cash flows lead to varied IRR
When the benefits are greater than the costs.
IRR is greater than the Discount Rate
When Costs are greater than Benefits
IRR is less than the Discount Rate
When benefits equal the Costs
IRR : Discount Rate
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.
Takes risk into consideration
2 year payback is less risky than a 5 year payback
Ignores the Time Value of Money
Exception: Discount payback method
Ignores cash flow after the initial investment is paid back
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.
Simple to use
People understand easily
Can be skewed based on Depreciation method that is used.
Ignores the Time Value of Money.