What is Capital Budgeting? How is it used?

Managerial Accounting technique used to evaluate different investment optionsHelps management make decisionsUses both accounting and non-accounting informationInternal focusGAAP is not mandatory

What values are used in Capital Budgeting?

Capital Budgeting ONLY uses Present Value tables. Capital Budgeting NEVER uses Fair Value.

When is the Present Value of $1 table used?

For ONE payment- ONE time.

When is the Present Value of an Annuity Due used?

Multiple payments made over time- where the payments are made at the START of the period.

When is the Present Value of an Ordinary Annuity of $1 (PVOA) used?

Multiple payments over time- where 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)?

A preferred method of evaluating profitability. One of two methods that use the Time Value of Money : PV of Future Cash Flows - Investment

How is NPV used to calculate future benefit?

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)

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 Net Present Value 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 a CPA Exam question says to include tax considerations- then you have to 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 the benefits are greater than the costs. IRR is greater than the Discount Rate

When is NPV on an Investment Negative?

When Costs are greater than Benefits IRR is less than the Discount Rate

When is NPV Zero?

When benefits equal the 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 / 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.

What are the strengths of the Payback Method?

Takes risk into consideration 2 year payback is less risky than a 5 year 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?

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.

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 that is used. Ignores the Time Value of Money.

What is an Expected Return?

An approximate rate of return on assets.