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Flashcards in Capital Budgeting Deck (26):
1

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

Simple to use. People understand easily.

2

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

3

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

4

What is Capital budgeting? How is it used?

Managerial accounting technique used to evaluate different investment options.
Helps management make decisions.
Used both accounting and non-accounting information.
Internal focus.
GAAP is not mandatory.

4

What values are used in Capital Budgeting?

Only present value tables.
Never uses fair value.

4

When is the Present Value of $1 table used?

For ONE payment-ONE time.

5

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.

7

What is an Expected Return?

An approximate rate of return on assets

8

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

9

What is the calculation for the Present Value of $1?

1/((1+i)^n)
i=interest rate
n=number of periods

10

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 benefits(Good Investment)
If NPV=0 - Management is indifferent

11

What is rate of return on an investment called?

The Discount Rate

12

What does the Discount Rate represent?

The rate of return on an investment used.
It represents the minimum rate of return required.

13

What are the strengths of the Net Present Value system?

Uses Time Value of Money.
Uses all cash flows- not just the cash flows to arrive at Payback.
Takes risks into consideration.

14

What are the weaknesses of the Net Present Value system?

Not as simple as the Accounting Rate of Return

15

How do Salvage Value and Depreciation affect Net Present Value?

NPV includes Salvage Value b/c it is future cash inflow.
NPV does NOT included depreciation b/c non cash.
Exception - If a CPA Exam question says to include tax considerations- then you have to include depreciation b/c of income tax savings generated by depreciation.

16

If multiple potential rates of return are available-which is used to calculate NPV?

The minimum rate of return is used.

17

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

18

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.

19

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

Rate of return for IRR = rate earned by investment
Rate of return for NPV = minimum rate

20

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

Strengths - Uses Time Value of Money - Cash Flow emphasis
Weaknesses- Uneven cash flows lead to varied IRR

21

When is NPV on an investment positive?

When the benefits are greater than the costs.
IRR is greater than discount rate.

22

When is NPV Zero?

When benefits equal the Costs
IRR: Discount rate

23

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 is a good investment. If payback is longer than target - it's a bad investment.

24

What are the strengths of Payback Method?

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

25

What are the weaknesses of the Payback Method?

Ignores Time Value of Money.
Exception: Discount payback method.
Ignores cash flow after the initial investment is paid back.