Ch 13 Flashcards
(29 cards)
What is capital budgeting?
The process of planning and evaluating long-term investments in projects or assets that generate future cash flows.
What type of decisions does capital budgeting focus on?
ong-term investment decisions involving assets with lives longer than one year.
Why are cash flows used instead of accounting earnings in capital budgeting?
Because cash flows reflect the actual inflow/outflow of money, while accounting earnings include non-cash items.
What are incremental cash flows?
Cash flows that occur directly as a result of accepting a project.
What are the five main investment evaluation methods?
AAR, Payback Period, NPV, IRR, and Profitability Index.
What is the formula for Average Accounting Return (AAR)?
AAR = Average Net Income ÷ Average Book Value.
What is the main weakness of the AAR method?
It does not use cash flows or account for the time value of money.
What does the payback period measure?
The time it takes to recover the initial investment.
What is the biggest limitation of the payback period method?
It ignores cash flows after the payback period and the time value of money.
What is the Net Present Value (NPV) formula?
NPV = Present Value of Future Cash Flows – Initial Investment.
What is the decision rule for NPV?
Accept the project if NPV > 0.
What is the Internal Rate of Return (IRR)?
The discount rate that makes the NPV of a project equal to zero.
When should a project be accepted using IRR?
If IRR > the cost of capital.
What is the formula for the Profitability Index (PI)?
PI = PV of Future Cash Flows ÷ Initial Investment.
What is the decision rule for the PI method?
Accept the project if PI > 1.
What is the cost of capital?
The required return needed to make a capital budgeting project worthwhile.
What does WACC stand for?
Weighted Average Cost of Capital.
Why is WACC used in capital budgeting?
It reflects the opportunity cost of capital and is used as the discount rate for NPV and IRR.
What is the Capital Cost Allowance (CCA)?
Tax-deductible depreciation used in Canada.
How does the CCA create a tax shield?
By reducing taxable income, which decreases taxes paid.
What is the tax shield formula?
Tax Shield = CCA × Tax Rate.
What is included in the initial investment calculation?
Purchase price, installation, working capital, minus salvage value of old asset and tax credits.
What are terminal year cash flows?
After-tax salvage value and recovery of working capital.
Should interest expense be included in project cash flows?
No. It’s already included in the discount rate (WACC).
