Flashcards in Capital Budgeting Module Deck (81):
Capital _________ is the process of selecting a company's long-term capital assets.
A company must determine which long-term _____________ to undertake to maximize owner wealth.
A _______ expenditure (CAPEX) is one where the returns are expected beyond the period of 12 months.
What does CAPEX stand for?
Capital Expenditure (CAPEX) is meant as a ________ investment and hence returns are expected to be long-lasting.
The main reasons behind CAPEX are to expand, replace or renew _____ assets and commitment of funds for other activities that are expected to reap future gains.
Fixed assets usually need to be replaced or renewed at some point for example outdated equipment or those needing repair. Expansion of fixed assets occurs during company ______. Other activities may be investment in research and development of new products, advertising etc.
The CAPEX process is undertaken to determine the suitability and selection of projects and consists of the following five steps: producing a proposal, review and analysis, decision making, implementation and _________.
___________ is a crucial step in the CAPEX process, to actually roll-out the project.
What are the five steps of the CAPEX process?
1) Producing a proposal
2) Review and analysis
3) Decision making
The two best known types of CAPEX projects are the ___________ and mutually exclusive projects.
What are the two known types of CAPEX projects?
Independent and Mutually exclusive projects
Independent projects have no correlation to each other and can be selected individually without impairing the chances of another project. However, mutually exclusive projects ________ with each other, with only one needing to be selected.
CAPEX budgeting decisions can be taken on the _____________ or ranking approach.
The ranking approach to CAPEX budgeting compares the investment options by some predetermined measure, for example, ___________.
rate of return
The accept-reject approach to CAPEX budgeting merely examines a projects ________.
CAPEX ____________ are routinely examined by the cash flow pattern.
Cash flow patterns allow financial managers to examine the in and outflows of funds for a particular investment. Cash flows may be __________, unconventional, a mixed stream or annuity.
The inflows of cash from an _______ are in equal amounts over a regular period.
It is called a nonconventional cash flow pattern because the initial outflow is then not followed by a ________ stream of inflows.
It is called a mixed stream if the pattern is not an annuity, in other words, the cash inflows are for _______ amounts of money.
The relevant cash flows must be examined to assess the _____ budgeting alternatives.
These are the cash flows that matter and assist in determining the suitability and profitability of a project. These cash flows include incremental flows (additional in or out flows that result from a project), the initial investment and operating cash inflows (after-tax cash inflows resulting from a project).
When examining a replacement CAPEX decision, the incremental tax flows must take into account the cost of the ____ investment, after-tax inflows from the new replacement asset and the after-tax inflow from the liquidation of the old asset.
The asset to be replaced must be liquidated and a value obtained in order to directly _______ the operating cash inflows of the old and new asset.
The _________ cost of a new asset and the after-tax proceeds of the old asset are the two types of cash flows to examine in calculating the initial investment of CAPEX.
It is not just the cost of the asset that is required but also the cost of installation of that asset to give a true cost of the asset.
Where the original purchase price of Asset A is $125,000, the book value of that asset is $100,000 and upon sale of that asset the price obtained was $110,000; then the difference in the sale price and book value is called recaptured ____________.
Recaptured depreciation is treated as _________ income and taxed as such.
In order to make the right CAPEX decisions, capital _________ techniques should be implemented by financial managers.
Capital budgeting techniques are used to analyze the various project proposals using methods like _________ rate of return.
Unsophisticated capital budgeting techniques do not consider the ____ value of money.
Unsophisticated capital budgeting techniques do not calculate the time value by _________ cash flows to determine present value.
The average rates of ______ and payback period are examples of unsophisticated capital budgeting techniques.
These are the two common techniques.
To calculate the average rate of return, average profit after taxes for the duration of the projects life is divided by the average _________.
Average Profit (After taxes for the duration of the projects) / Average Investment = Rate of Return
The average investment is calculated by halving the ____ investment.
When applying the average rate of return technique, the project is accepted where the minimum average rate of return is ________.
Companies set their own acceptable average rate of return, so if the calculation for a project is greater than that figure, then it will be accepted. However, if the company also uses a _______________ rank, then the project with the better average rate of return will be selected.
The payback period method of capital budgeting calculates the amount of ____ necessary for a project investment to recoup its initial investment.
The payback period method calculates the cash ______ over time.
In making a decision using the payback period method, a project is accepted where the payback period is less than the _________ payback period as stated by a company.
Where the payback period is less than the maximum allowable, the initial investment is recouped within a ________ acceptable to the company.
As a capital budgeting technique, the payback period is more ________ than the average rate of return.
The payback period is more accurate as it considers real cash flows rather than accounting profits and because it indirectly considers the ________ of money through the timing of cash flows.
The three main sophisticated capital budgeting techniques are the net present value (NPV), profitability index (PI) and ________ rate of return.
These are the 3 most popular techniques that take into account time value of money.
What are the three main sophisticated capital budgeting techniques?
1) Net present value (NPV)
2) Profitability Index (PI)
3) Internal rate of return
These are the 3 most popular techniques that take into account time value of money.
_____ is calculated by subtracting the initial investment from the present value of cash inflows.
NPV (Net present value)
What does IRR stand for?
Internal Rate of Return (IRR)
What does NPV stand for?
Net present value (NPV)
What does PI stand for?
Profitability Index (PI)
If NPV is greater than ____, then a project should be accepted.
This is because above the $0 level, the cost of capital will be less than the return from the project.
The PI is calculated by taking the present value of cash inflows and dividing it by the initial __________.
Present value of cash inflows/initial investment = PI (Profitability Index)
Projects with a PI (Profitability Index) lower than 1 should be ________.
Where the PI (Profitability Index) is 1 or more, then the ____ will exceed $0.
NPV (Net Present Value)
The IRR (Internal rate of return) is the ________ rate that results in a net present value (NPV) of zero for a series of future cash flows.
This is the definition for IRR, which ensures that the present value of cash inflows equals the initial investment.
A financial manager should accept a project where the IRR (Internal rate of return) is greater than the cost of _______.
Where the IRR(Internal rate of return) is greater than the cost of capital, the company will be making a rate of return higher than the initial investment and hence increase _______ to the company's owners.
Ranking of projects will be critical when the projects are mutually _________.
This is because one project has to be chosen at the expense of another; hence ranking will help financial managers make the better choice.
_________ can conflict when using the NPV and IRR method because of intermediate cash flows.
___________ cash flows are treated differently by the 2 methods. In NPV (Net present value), the assumption is that it is reinvested at the cost of capital, whereas in IRR the assumption is it is reinvested at a rate equal to the projects IRR (Internal rate of return).
Where a company has unlimited funds, then capital budgeting is straightforward; however, most companies have to apply capital ________ because it has a limited pool of funds and a variety of competing projects to choose from.
__________ has to take place because the reality is that companies do not have a bottomless pit of money to undertake any project it likes.
When capital rationing, a company can use an ________ opportunities schedule (IOS) to graph the internal rate of return of the competing projects in descending order against the total dollar investment.
The ______ limit will dictate which projects are acceptable within dollar constraints but cannot determine which one will maximize owner wealth.
What does IOS stand for?
Investment opportunities schedule (IOS)
Using the ____ approach to capitol rationing will ensure that the projects selected will maximize owner wealth.
NPV (Net present value)
This approach determines the mixture of opportunities with the greatest overall present value.
_______ risk can be determined by the scenario and sensitivity analysis, statistical analysis, decision trees and simulation.
How can Project risk be determined?
Scenario and sensitivity analysis, statistical analysis, decision trees and simulation.
Sensitivity analysis is a _________ approach using a specified variable with several possible values to determine the effect on return. The scenario analysis is similarly a behavioral approach but has a wider scope.
Risk can be assessed via the statistical concepts of expected value and _______ deviation and building a table of possible results.
Standard deviation is the measure of ________ around the expected outcome.
Expected value is the weighted average of possible results from a particular project multiplied by their probability of _________.
__________ uses a variety of random variables as inputs for analyzing risk.
The simulation approach is a _________ orientated behavioral method of analyzing risk.
When conducting a capital budgeting exercise using NPV, we need to either adjust the discount rate or cash inflow to reflect ____.
_______ rate = (risk adjusted discount rate RADR). This is one of the two main methods of building in risk to the calculation for NPV in capital budgeting.
When adjusting the cash inflows for risk assessment, this process is called certainty ___________.
Certainty equivalents (CEs) represent the portion of estimated cash inflows which investors are happy to definitely receive as opposed to cash inflows that are _________.
Expected cash inflows are converted to CEs and then __________ using the risk free rate.
What does CE stand for?
Certainty equivalents (CE)
The risk-free rate is a rate of return on a practically ________ investment, for example, US Treasury bills.
The _____________ discount rate (RADR) is the rate of return that must be earned on a particular project in order to maintain or improve the company's share price.