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

Internal focus

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

(PVOA) used?

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 __

( 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

__ - Investment__

NPV

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 __

Avg Investment

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.