capital budgeting Flashcards
(23 cards)
what is capital budgeting?
how managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and introduction of new products
what are typical capital budgeting decisions?
- plant expansion
- equipment selection
- lease or buy
- equipment replacement
- cost reduction
what are the two broad categories of capital budgeting decisions?
screening decisions - does a proposed project meet some preset standard of acceptance?
preference decisions - selecting from among several competing courses of action
what is the time value of money?
- business investments extend over long periods of time, so we must recognise the time value
- investments that promise returns earlier in time are preferable to those that promise returns later in time
what is an annuity?
an investment that involves a series of identical cash flows at the end of each year
how do we determine the Net Present Value (NPV)?
calculate the present value of cash inflows
calculate the present value of cash outflows
subtract the present value of the outflows from the present value of the inflows
what is the general decision rule for NPV?
if NPV is, the project is;
positive - acceptable, since it promises a return greater than the required rate of return
zero - acceptable, since it promises a return equal to the required rate of return
negative - not acceptable, since it promises a return less than the required rate of return
why is depreciation not deducted computing the present value of a project?
- it is not a current cash outflow
- discounted cash flow methods automatically provide for return of the original investment
how to choose a discount rate?
- firm’s cost of capital is usually regarded as the most appropriate choice for the discount rate
- the cost of capital is the average rate of return the company must pay to its long-term creditors and shareholders for the use of their funds
what is the internal rate of return method?
- the interest yield promised by an investment project over its useful life
- it is computed by finding the discount rate that will cause the NPV of a project to be zero
what is the equation for IRR?
PV factor for the IRR = investment required/net annual cash flows
how to calculate the IRR?
a% + (A/A-B) x (b-a)%
where a = lowest discount factor used
b = highest discount factor used
A = NPV of a
B = NPV of b
NPV vs IRR
- NPV is easier to use
- assumes cash inflows will be reinvested at the discount rate - realistic assumption
what are the other approaches to capital budgeting decisions?
payback method
accounting/simple rate of return
what is the payback period?
length of time it takes for a project to recover its initial cost out of the cash receipts that it generates
how do you calculate payback period?
payback period = investment required/net annual cash inflow
what is the evaluation of the payback method?
ignored time value of money
ignores cash flows after the payback period
what is the accounting rate of return method?
- does not focus on cash flows but it focuses on accounting income
what is the formula for ARR?
incremental revenues - incremental expenses, including depreciation/ initial investment
what is the evaluation of NPV
- basic method that should be used
- takes account of all cash-flows, including investments, and treats them equally
- it takes account of the time at which cash flows occurs
- it takes account of the shareholders expected rate of return
what is the evaluation of IRR
there are occasions when IRR and NPV will disagree in selecting investments. This is not common.
However, of the two NPV should always be the basis for decision
what is the evaluation of ARR?
may be useful as a quick initial assessment
NPV should be used before a final decision
what is the evaluation of the payback method
results are reliable
use for a quick assessment
