Flashcards in Capital Budgeting Deck (47):
What is Capital Budgeting? How is it used?
Managerial Accounting technique used to evaluate different investment options
Helps management make decisions
Uses both accounting and non-accounting information
GAAP is not mandatory
E.g. Answers questions such as:
1) should machinery be replaced by more expensive but more efficient models?
2) should a new product or market be added?
3) should existing debt be extinguished or refinanced?
4) how can a constrained resource best be used?
What is Capital Budgeting? How is it used?
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. ALWAYS AT BEGINNING OF THE PERIOD NEVER AT THE END.
When is the Present Value of an Ordinary Annuity of $1 (PVAD) 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.
What is the relevant data used in Capital Budgeting that is cash flow oriented? Essentials?
- Initial Investment
- Future net cash inflows or net savings in cash outflows
Accrual basis while relevant for financial reporting is NOT relevant for Capital budgeting. because the relevant project is concerned with cash flows.
TVM Is highly important as these decisions are greater than one year in duration.
What the primary approaches used for capital budgeting? which includes screening project possibilities and ranking existing choices?.the seven commonly used techniques are? and four Methods or Models are best used for long-range decision making?
1. Payback Method
2. Discounted Payback
3. Accounting Rate of Return
4. Net Present Value
5. Internal Rate of Return
6. Profitability Index
7. CVP Analysis/Margin of Safety...huh is this divided by or ??? not sure...
the best choices for Long-range decision making are
1. Payback Method
2. Accounting Rate of Return Model
3. Unadjusted Rate of Return Model
4. Discounted Cash Flow Model - THIS ONE IS CONSIDERED BEST FOR LONG-RANGE DECISIONS..because FV and PV are considered.
Payback model and accounting rate of return models do not consider time value of money.
What is Market Risk?
Possibility of Loss due to market changes.
What is Legal Risk?
Possibility of loss from legal or "regulatory" action.
What is Basis Risk?
Basis risk is the possibility of loss from ineffective hedging activities.
Credit risk is the possibility of loss as a result of the counterparty to the agreement failing to meet its obligation.
How do you determine Future Cash Flows from Investment decision using NPV method?
Determining Future Cash Flows
First determe relevant cash flows in the decision. Simply stated, relevant cash flows are those that are expected to differ among the alternatives. Examples of relevant cash flows include
a. Initial investment in long-term tangible or intangible assets for each investment alternative
b. Any initial investment in working capital for each investment alternative, (e.g., inventories, accounts receivable, etc.)
c. Cash flow from the sale of any assets being replaced
d. Differences in cash flow from operations under the alternatives, (e.g., cash inflow from sales and/or cash outflows for operating costs)
• Remember to focus on cash flows not accounting income
• Payments for incremental income taxes should be included
• Depreciation expense does not affect cash flows but the firm receives a tax savings (shield) from depreciation expense. It reduces taxable income and therefore reduces tax payments.
• Remember it is tax depreciation that generates the tax shield, and book depreciation may differ from tax depreciation.
e. Cash flows at the end of the expected life of the project.
• Terminal disposal price of any long-term tangible or intangible assets. If the tax basis (Initial cost – Tax depreciation taken) is expected to be different from the disposal price, the tax gain or loss will generate a tax inflow or outflow.
• Recovery of any working capital investment—This investment will be recovered at the end of the project by liquidation of inventories, accounts receivable, etc. There are generally no tax implications of this recovery because it is assumed that the cash received will be equal to the book value (tax basis) of the working capital items.
Explain Proceeds from the Sale of Bond.
Bond sale has two cash flows to be calculated:
1. periodic interest payments
2. principal due at the end of the bond's life.
Both cash flows are discounted at the prevailing market rate of interest at the time of bond issuance.
How do you compute Economic Rate of Return on Common Stock?
(Dividends +Change in Price) divided by beginning price.
Because return on stock is measured by the return to the investor both in appreciation and in dividends.
What is Market price divided by EPS best know as formula?
This is known as the price earnings ratio.
(Net income - preferred dividend) divided by CS outstanding.
Which is a good phrase to define IRR on a project as it relates to discount rate and NPV?
the internal rate of return on a project is the discount rate at which the net present value of the project equals zero.
The zero-coupon method is used in determining?
FV of Interest rate swaps.
The zero-coupon method is a present value model in which the net settlements from the swap are estimated and discounted back to their current value. The key variables in the model include
• Estimated net settlement cash flows (explained in the example below).
• Time of the cash flows as specified by the contract.
• Discount rate.
EXAMPLE: Assume that management enters into an agreement to swap payments on a fixed-rate liability for a variable rate. If interest rates decline, the firm will receive a net positive cash flow from the swap because the amount received on the fixed rate will be greater than the amount due on the variable rate. The opposite is true if rates increase. The zero-coupon method estimates future cash flows by calculating the net settlement that would be required if future interest rates are equal to the rates implied by the current yield curve. That amount is discounted back to determine the current fair value of the swap for financial reporting purposes.
Excess present value (profitability) index
Computes ratio of pv of cash inflows to initial cost of project. Used to implement the NPV method when there is a limit on funds available for capital investments. Assuming all other factors are equal it's goal is accomplished by allocating funds to those projects with the highest excess present value indexes.
First compute NPV of each alternative using min RRR.
The excess PVI is computed:
PV of future net cash inflows
______________________ x 100 = excess PV Index
If the index results in equal to or greater than 100% then the project will generate equal to or greater than RRR.
Net present value methods which are the most widely accepted methods of evaluating a capital expenditure have advantages and limitations, explain both.
•Presents results in dollars which are easily understood
•Adjusts for the time value of money
•Considers the total profitability of the project
•Provides a straightforward method of controlling for the risk of competing projects—higher-risk cash flows can be discounted at a higher interest rate
•Provides a direct estimate of the change in shareholder wealth resulting from undertaking a project
Limitations of net present value methods include
• May not be as simple or intuitive as other methods
• Does not take into account the management flexibility with respect to a project—management may be able to adjust the amount invested after the first year or two depending on the actual returns.
Do IRR and NPV both assume that cash flows will be reinvested at the rate earned by the investment?
IRR does make this assumption whereas NPV does not.
Does consider salvage value in event of equipment replacement
Does NOT consider time value of money
Does NOT measure or compare profitability of projects.
PAYBACK METHOD ONLY INDICATES "WHEN" INVESTMENT IS RECOVERED.
A project has a present value of future net cash inflows of $120,000 and an initial investment of $110,000. Calculate the excess present value index for the project.
calculated as follows:
Present value of future net cash inflows ÷ Initial investment × 100
= $120,000/110,000 × 100
= 109.1% excess present value index