Flashcards in Capital Budgeting 2 Deck (14):

1

## What is the Internal Rate of Return (IRR)?

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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

2

## 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.

3

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

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

Rate of return for NPV is the minimum rate.

4

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

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Strengths: Uses Time Value of Money- Cash Flow emphasis

Weakness: Uneven cash flows lead to varied IRR

5

## When is NPV on an Investment positive?

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When the benefits are greater than the costs.

IRR is greater than the Discount Rate

6

## When is NPV on an Investment Negative?

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When Costs are greater than Benefits

IRR is less than the Discount Rate

7

## When is NPV Zero?

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When benefits equal the Costs

IRR : Discount Rate

8

## What is the Payback Method? How is it calculated?

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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.

9

## What are the strengths of the Payback Method?

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Takes risk into consideration

2 year payback is less risky than a 5 year payback

10

## What are the weaknesses of the payback method?

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Ignores the Time Value of Money

Exception: Discount payback method

Ignores cash flow after the initial investment is paid back

11

## What is the Accounting Rate of Return?

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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.

12

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

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Simple to use

People understand easily

13

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

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Can be skewed based on Depreciation method that is used.

Ignores the Time Value of Money.

14