Flashcards in Capital Budgeting Deck (32):
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
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
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.
What does the Discount Rate represent?
AKA Hurdle or Target Rate
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.
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 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 are some ways to Analyze Risk/Probabilistic Approaches to determining the strength of NPV calculations?
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
What is the Total Return of an Asset and the assumption of the Gordon Growth Model?
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
What is a common way to estimate expected returns based on prior history?
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