Flashcards in Capital Budgeting Deck (28):

1

## What is Capital Budgeting? How is it used?

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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

## What values are used in Capital Budgeting?

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"Capital Budgeting ONLY uses Present Value tables.

Capital Budgeting NEVER uses Fair Value."

3

## When is the Present Value of $1 table used?

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For ONE payment- ONE time.

4

##
When is the Present Value of an Annuity Due used?

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

5

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

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

Think A for Arrears."

6

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

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"1 / (( 1+i )^n)

i : interest rate

n : number of periods"

7

##
What is Net Present Value (NPV)?

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"A preferred method of evaluating profitability.

One of two methods that use the Time Value of Money

: PV of Future Cash Flows - Investment"

8

##
How is NPV used to calculate future benefit?

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"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

##
What is the rate of return on an investment called?

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The Discount Rate.

10

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What does the Discount Rate represent?

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"The rate of return on an investment used.

It represents the minimum rate of return required."

11

##
What are the strengths of the Net Present Value system?

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"Uses the Time Value of Money

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

Takes risks into consideration"

12

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What are the weaknesses of the Net Present Value system?

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Not as simple as the Accounting Rate of Return.

13

##
How do Salvage Value and Depreciation affect Net Present Value?

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"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

##
If multiple potential rates of return are available- which is used to calculate Net Present Value?

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The minimum rate of return is used.

15

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What is the Internal Rate of Return (IRR)?

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"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

##
Which rate of return is used to re-invest cash flows for Internal Rate of Return?

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Cash flows are re-invested at the rate of return earned by the original investment.

17

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

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"Rate of return for IRR is the rate earned by the investment.

Rate of return for NPV is the minimum rate."

18

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

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"Strengths: Uses Time Value of Money- Cash Flow emphasis

Weakness: Uneven cash flows lead to varied IRR"

19

##
When is NPV on an Investment positive?

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"When the benefits are greater than the costs.

IRR is greater than the Discount Rate"

20

##
When is NPV on an Investment Negative?

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"When Costs are greater than Benefits

IRR is less than the Discount Rate"

21

##
When is NPV Zero?

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"When benefits equal the Costs

IRR : Discount Rate"

22

##
What is the Payback Method? How is it calculated?

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"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

##
What are the strengths of the Payback Method?

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"Takes risk into consideration

2 year payback is less risky than a 5 year payback

"

24

##
What are the weaknesses of the payback method?

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"Ignores the Time Value of Money

Exception: Discount payback method

Ignores cash flow after the initial investment is paid back"

25

##
What is the Accounting Rate of Return?

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"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

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

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"Simple to use

People understand easily"

27

##
What are the weaknesses of the Accounting Rate of Return (ARR)?

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"Can be skewed based on Depreciation method that is used.

Ignores the Time Value of Money."

28