Flashcards in Capital Budgeting Deck (32):

2

## 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

3

## What values are used in Capital Budgeting?

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Capital Budgeting ONLY uses Present Value tables.

Capital Budgeting 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.

6

## 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.

7

## 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

8

## 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

9

## What is the rate of return (hurdle/target rate) on an investment called and what is it based on?

### The Discount Rate based on the market rate of return for projects with similar risks.

10

##
What does the Discount Rate represent?

AKA Hurdle or Target Rate

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The rate of return on an investment used.

It represents the minimum rate of return required.

It should not be lower than the cost of capital/ because that is the rate at which the company is charged for it's capital.

11

## 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)

12

## 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

13

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

### Not as simple as the Accounting Rate of Return.

14

## 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.

15

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

### The minimum rate of return is used.

16

## 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

17

## 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.

18

## 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.

19

## 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

20

## 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

21

## When is NPV on an Investment Negative?

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When Costs are greater than Benefits

IRR is less than the Discount Rate

22

## When is NPV Zero?

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When benefits equal the Costs

IRR = Discount Rate

23

## 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.

24

## 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

25

## 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

26

## 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.

27

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

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Simple to use

People understand easily

28

## 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.

29

## What is an Expected Return?

### An approximate rate of return on assets.

30

## What are some ways to Analyze Risk/Probabilistic Approaches to determining the strength of NPV calculations?

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Sensitivity Analysis - explores the importance of assumptions underlying a forecast.

Scenario Analysis - the effects of changes in a group of related variables - a more complex variation of sensitivity analysis

Simulation Models - software that makes it possible to model the effects of even more economic conditions

Decision Trees - multiple decisions that are involved in implementing a project

Real Options - views an investment as a purchasing option

31

## What is the Total Return of an Asset and the assumption of the Gordon Growth Model?

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The total return of as investments includes cash dist. (interest & dividends) and the change in value of an asset Total Return = Distribution Rate + Growth Rate.

The Gordon Growth Model assumes that reinvested assets will increase distributions by the amount of the reinvestment and will end up growth in assets = growth in future dividends

32

## What is a common way to estimate expected returns based on prior history?

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Arithmetic Average (Simple Average) ideal for investments with short holding periods

Geometric Average - the consistent return that would grow to the same final result as actual returns of several different periods (compounding) and better for estimating investments with long holding periods

33