What is Capital Budgeting?
How is it used?
Managerial Acctg technique used to evaluate different investment options
Helps mgmt make decisions
Uses both Acctg + Non-acctg info
GAAP is not mandatory
What values are used in Capital Budgeting?
ONLY uses PV tables
NEVER uses Fair Value
When is the PV of $1 table used?
For ONE payment- ONE time.
When is the PV of an Annuity Due used?
Multiple payments made over time
Payments are made at the START of the period
When is the PV of an Ordinary Annuity of $1
Multiple payments over time
payments are made at the END of the period
Think A for Arrears
What is the calculation for the Present Value of $1?
( 1 + i )n
i = interest rate
n = number of periods
What is Net Present Value (NPV)?
Preferred method of evaluating profitability
One of two methods that use the Time Value of Money
PV of Future Cash Flows
How is NPV used to calculate future benefit?
NPV = PV Future Cash Flows - Investment
If NPV is Negative, Cost > benefits (bad investment)
If NPV is Positive, Cost < benefit (good investment)
If NPV = 0, Cost = Benefit (Mgmt is indifferent)
What is the rate of return on an investment called?
The Discount Rate.
What does the Discount Rate represent?
The rate of return on an investment used.
It represents the minimum rate of return required.
What are the strengths of the NPV system?
Uses the Time Value of Money
Uses all cash flows- not just the cash flows to arrive at Payback
Takes risks into consideration
What are the weaknesses of the
Net Present Value system?
Not as simple as the
Accounting Rate of Return.
How do Salvage Value and Depreciation
affect Net Present Value?
NPV includes Salvage Value because it is a future cash inflow.
NPV does NOT include depreciation because it is non-cash.
Exception! If NPV includes tax considerations, include depreciation because of income tax savings generated by depreciation.
If multiple potential rates of return are available
which is used to calculate Net Present Value?
The minimum rate of return is used.
What is the Internal Rate of Return (IRR)?
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
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.
How does the rate used for Internal Rate of Return (IRR) compare to that used for Net Present Value (NPV)?
Rate of return for IRR is the rate earned by the investment.
Rate of return for NPV is the minimum rate.
What are the strengths and weaknesses
of the Internal Rate of Return system?
Strengths: Uses Time Value of Money- Cash Flow emphasis
Weakness: Uneven cash flows lead to varied IRR
When is NPV on an Investment positive?
When benefits > costs.
IRR > Discount Rate
When is NPV on an Investment Negative?
When Costs > Benefits
IRR < Discount Rate
When is NPV Zero?
When benefits = Costs
IRR = Discount Rate
What is the Payback Method?
How is it calculated?
It measures an investment in terms of how long it takes to recoup the initial investment via Annual Cash Inflow
Investment = Payback Method
Annual Cash Inflow
Compare to a targeted timeframe
If payback is shorter than target, good investment.
If payback takes longer, bad investment.
What are the strengths of the Payback Method?
Takes risk into consideration
2 yr payback is less risky than a 5 yr payback
What are the weaknesses of the payback method?
Ignores the Time Value of Money
Exception: Discount payback method
Ignores cash flow after the initial investment is paid back
What is the Accounting Rate of Return?
Approximate rate of return on assets
ARR = Net Income
Compare to a targeted return rate
If ARR greater than target, good investment
If ARR less than target, bad investment
What are the strengths of the Accounting Rate of Return (ARR)?
Simple to use
People understand easily
What are the weaknesses of the Accounting Rate of Return (ARR)?
Can be skewed based on Depreciation method
Ignores the Time Value of Money
What is an Expected Return?
An approximate rate of return on assets.