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Flashcards in Capital Budgeting Deck (28)
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1
Q
What is Capital Budgeting? How is it used?
A
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
2
Q
What values are used in Capital Budgeting?
A
Capital Budgeting ONLY uses Present Value tables.

Capital Budgeting NEVER uses Fair Value.
3
Q
When is the Present Value of $1 table used?
A
For ONE payment- ONE time.
4
Q
When is the Present Value of an Annuity Due used?
A
Multiple payments made over time- where the payments are made at the START of the period.
5
Q
When is the Present Value of an Ordinary Annuity of $1 (PVOA) used?
A
Multiple payments over time- where payments are made at the END of the period.

Think A for Arrears.
6
Q
What is the calculation for the Present Value of $1?
A
1 / (( 1+i )^n)

i : interest rate
n : number of periods
7
Q
What is Net Present Value (NPV)?
A
A preferred method of evaluating profitability.

One of two methods that use the Time Value of Money

: PV of Future Cash Flows - Investment
8
Q
How is NPV used to calculate future benefit?
A
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)
9
Q
What is the rate of return on an investment called?
A
The Discount Rate.
10
Q
What does the Discount Rate represent?
A
The rate of return on an investment used.

It represents the minimum rate of return required.
11
Q
What are the strengths of the Net Present Value system?
A
Uses the Time Value of Money

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

Takes risks into consideration
12
Q
What are the weaknesses of the Net Present Value system?
A
Not as simple as the Accounting Rate of Return.
13
Q
How do Salvage Value and Depreciation affect Net Present Value?
A
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.
14
Q
If multiple potential rates of return are available- which is used to calculate Net Present Value?
A
The minimum rate of return is used.
15
Q
What is the Internal Rate of Return (IRR)?
A
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
16
Q
Which rate of return is used to re-invest cash flows for Internal Rate of Return?
A
Cash flows are re-invested at the rate of return earned by the original investment.
17
Q
How does the rate used for Internal Rate of Return (IRR) compare to that used for Net Present Value (NPV)?
A
Rate of return for IRR is the rate earned by the investment.

Rate of return for NPV is the minimum rate.
18
Q
What are the strengths and weaknesses of the Internal Rate of Return system?
A
Strengths: Uses Time Value of Money- Cash Flow emphasis

Weakness: Uneven cash flows lead to varied IRR
19
Q
When is NPV on an Investment positive?
A
When the benefits are greater than the costs.

IRR is greater than the Discount Rate
20
Q
When is NPV on an Investment Negative?
A
When Costs are greater than Benefits

IRR is less than the Discount Rate
21
Q
When is NPV Zero?
A
When benefits equal the Costs

IRR : Discount Rate
22
Q
What is the Payback Method? How is it calculated?
A
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.
23
Q
What are the strengths of the Payback Method?
A
Takes risk into consideration

2 year payback is less risky than a 5 year payback
24
Q
What are the weaknesses of the payback method?
A
Ignores the Time Value of Money

Exception: Discount payback method

Ignores cash flow after the initial investment is paid back
25
Q
What is the Accounting Rate of Return?
A
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.
26
Q
What are the strengths of the Accounting Rate of Return (ARR)?
A
Simple to use

People understand easily
27
Q
What are the weaknesses of the Accounting Rate of Return (ARR)?
A
Can be skewed based on Depreciation method that is used.

Ignores the Time Value of Money.
28
Q
What is an Expected Return?
A
An approximate rate of return on assets.