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Flashcards in Capital Budgeting Into & Project Risk Deck (12):

Project Ranking Decisions

Resource constraints (in short-run); must allocate resources to most beneficial projects



Payback period approach - ranks projects based on how quickly invested capital is recovered;

Uses nominal dollars, not discounted


DPP Discounted payback period approach

How quickly invested capital is recovered using discounted cash flows;


Accounting rate of return ARR

Annoaul incremental accrual-baed net income as a percentage of initial investment;

Higher percent = higher ranking

Uses accrual value not cash flows


NPV - Net present value approach

Ranks projects based on there relative net present values

Higher net present value = Higher ranking

Recognizes the time value of money


IRR - Internal rate of return approach

Higher internal rate = higher ranking

It recognizes the time value of money



May result in different rankings due to differences in:
1) Project investment cost
2) timing of cash flows
3) life of project


PI Approach

Profitability index approach - Ranks base on net present value of each project as a percentage of initial investment cost of each


Capital Budgeting

Process of measuring, selecting, and evaluating log-term investment opportunities


Project Risks

Risk = possibility of loss or other unfavorable result resulting from implicit future decisions

Reward - Benefit expected or required from investment in capital project (greater perceived risk, the greater the reward)


Risk-Reward Relationship

Expected Reward = Y; Perceived Risk = X


Disount/Hurdle Rate

As described in the "Cost Concepts" section, while the cost of capital can be determined for each element of capital (e.g., long-term notes, bonds, preferred stock, common stock, etc.), it is usually appropriate to calculate and use the weighted average cost of capital. Specifically, the cost of capital for each element is weighted by the proportion of total capital provided by each element. The resulting weighted average is the rate of return that a firm must expect to earn on a project it undertakes. In evaluating projects, that rate is called the hurdle rate or discount rate.

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