Capital Budgeting - Module 43

Question 1

What is Capital Budgeting? How is it used?

Answer 1

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

Question 2

What values are used in Capital Budgeting?

Answer 2

Capital Budgeting ONLY uses Present Value tables.

Capital Budgeting NEVER uses Fair Value.

Question 3

When is the Present Value of $1 table used?

Answer 3

For ONE payment- ONE time.

Question 4

When is the Present Value of an Annuity Due used?

Answer 4

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

Question 5

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

Answer 5

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

Think A for Arrears.

Question 6

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

Answer 6

1 / (( 1+i )^n)i : interest raten : number of periods

Question 7

What is Net Present Value (NPV)?

Answer 7

A preferred method of evaluating profitability.

One of two methods that use the Time Value of Money: PV of Future Cash Flows - Investment

Question 8

How is NPV used to calculate future benefit?

Answer 8

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)

Question 9

What is the rate of return on an investment called?

Answer 9

The Discount Rate.

Question 10

What does the Discount Rate represent?

Answer 10

The rate of return on an investment used.

It represents the minimum rate of return required.

Question 11

What are the strengths of the Net Present Value system?

Answer 11

Uses the Time Value of Money

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

Takes risks into consideration

Question 12

What are the weaknesses of the Net Present Value system?

Answer 12

Not as simple as the Accounting Rate of Return.

Question 13

How do Salvage Value and Depreciation affect Net Present Value?

Answer 13

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.

Question 14

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

Answer 14

The minimum rate of return is used.

Question 15

What is the Internal Rate of Return (IRR)?

Answer 15

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

Question 16

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

Answer 16

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

Question 17

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

Answer 17

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

Question 18

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

Answer 18

Strengths: Uses Time Value of Money- Cash Flow emphasis

Weakness: Uneven cash flows lead to varied IRR

Question 19

When is NPV on an Investment positive?

Answer 19

When the benefits are greater than the costs.

IRR is greater than the Discount Rate

Question 20

When is NPV on an Investment Negative?

Answer 20

When Costs are greater than Benefits

IRR is less than the Discount Rate

Question 21

When is NPV Zero?

Answer 21

When benefits equal the Costs

IRR : Discount Rate

Question 22

What is the Payback Method? How is it calculated?

(pg. 185)

Answer 22

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.

Question 23

What are the strengths of the Payback Method?

(pg. 185)

Answer 23

Takes risk into consideration

2 year payback is less risky than a 5 year payback

Question 24

What are the weaknesses of the payback method?

(pg. 185)

Answer 24

Ignores the Time Value of Money

Exception: Discount payback method

Ignores cash flow after the initial investment is paid back

Question 25

What is the Accounting Rate of Return? (pg. 185)

Answer 25

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.

Question 26

What are the strengths of the Accounting Rate of Return (ARR)? (pg. 185)

Answer 26

Simple to use People understand easily

Question 27

What are the weaknesses of the Accounting Rate of Return (ARR)? (pg. 185)

Answer 27

Can be skewed based on Depreciation method that is used. Ignores the Time Value of Money.

Question 28

What is an Expected Return?

Answer 28

An approximate rate of return on assets.

Question 29

Define Market Risk

Answer 29

The risk that a sluggish economy will affect the value of a debt instrument

Question 30

Define Sector Risk

Answer 30

The risk that an event in the investment's business sector will harm the investment For example- the banking sector is sluggish- so even stocks of healthy banks suffer

Question 31

Define Credit/Default Risk

Answer 31

The risk that a debtor will be unable to make loan payments or pay back the principal

Question 32

Define Interest Rate Risk

Answer 32

The risk that a change in interest rates will adversely affect the value of the note Example: Bond is for 10% but prevailing market rate is now 12%. If bondholder wants to sell it- they will have to sell it at a discount.

Question 33

What does Standard Deviation measure?

Answer 33

It measures the volatility of an investment.

Question 34

What is Systematic Risk?

Answer 34

Risk that impacts the entire market and can't be avoided or reduced through diversification Example: Wars

Question 35

What is Unsystematic Risk?

Answer 35

Relates to a particular industry or company Example: You own stocks in ethanol plants and an untimely freeze kills all of the corn in the Midwest

Question 36

What does Beta measure?

Answer 36

Beta measures how volatile the investment is relative to the rest of the market. In other words- how quickly (and in what amount) does the value of the stock change when the market sways?

Question 37

What is Variance?

Answer 37

It compares volatility of an investment to the market average. Factors include both Systematic and Unsystematic Risk.

Question 38

What is a Derivative?

Answer 38

An asset whose value is DERIVED from the value of another asset. Derivatives are measured at Fair Value.

Question 39

How is an Option used?

Answer 39

Gives the buyer the option to buy or sell a financial derivative at a certain price Traders use them to speculate where they think the price will be at a certain point and make a profit Hedgers use them to offset risk

Question 40

What is a Future?

Answer 40

A Forward Contract with a future value. They are sold and traded on the futures market.

Question 41

What is an Interest Rate Swap?

Answer 41

Forward Contract to swap payment agreements They are highly liquid and often valued using the Zero-Coupon method. Example: Steve pays Sally a fixed payment with a fixed interest rate. Sally pays Steve a variable payment tied to a benchmark such as LIBOR

Question 42

What is Legal Risk?

Answer 42

Risk that a law or regulation will void the derivative

Question 43

What is a Fair Value Hedge?

Answer 43

Hedge that protects against the value of an asset or liability changing. Changes in value are reported in earnings.

Question 44

What is a Cash Flow Hedge?

Answer 44

A hedge that protects against a set of future cash flows changing. Changes in value are reported in OCI.

Question 45

What is a Foreign Currency Hedge?

Answer 45

A hedge that protects against the value of a foreign currency changing. For example- a foreign currency hedge might be used to protect against the following: If you have receivables denominated in a foreign currency and that currency dips in value - your receivables are worth less than before.