Chapter 13: Decisions 2(Strategic Investment Decisions) Flashcards
(11 cards)
What is capital budgeting?
-Capital budgeting is the process of making long-term planning decisions for investment.
-It involves ultiple time periods. Therefore, cost data should be collected based on a life-sycle framework.
-The focus of capital budgeting should be on the entire life of the project, considering all cash inflows or cash saving.
What are the financial measures of capital budgeting?
-The non discounted cash flow methods includes payback period, and accounting rate of return.
-The discounted cash flow methods includes net present value, and internal rate of return.
What are the four non-financial measures of capital budgeting?
1) Quality of production, rework, scrap
2) Social responsibility
3) Employee Morale (lay-off, changing of position)
4) Supplier and Customer Relations
Explain to me the payback period method of capital budgeting?
-With the payback period method, the key focus is on time.
-If cashflows are equal each year: payback period=Initial Investment/Annual Cash Flow
-If cash flows are unequal you add each year’s cash flow until the total equals the initial investment.
-If the payback period is greater than the cutoff, we accept.
-If the payback period is less than the cutoff, we reject.
Explain to me the AAR(%) method of capital budgeting(it’s also known as ROI)?
-AARR=Accounting Income/Initial Investment
-If AARR>Required Rate of Return (RRR), then we accept.
-If AARR<RRR, then we reject.
How do we calculate NPV? how do we make the decision around NPV?
-NPV=Cash In-Flows+Residual Value-Investment Purchase Price
-If the NPV is greater than or equal to 0, we accept it. If the NPV is less than 0 we reject it.
-With net present value, when calculating the net initial investment, we also factor in cost of disposal of asset, as well as changes in working capital.
-When calculating terminal value or residual value, we also adjust for changes in net working capital, and of course we must discount the residual value back to the present by using the present value function.
-When discounting cash in-flows back to the present, we use RRR, and uniform cash inflows are discounted using PVIFA, and non-uniform cash inflow is discounted using PVIF.
How do we calculate IRR? how do we make the decision around IRR?
-The IRR is the discount rate that makes the NPV=0.
-If IRR is greater than or equal to the required rate of return, then we accept.
-If IRR is less than or equal to the required rate of return, then we reject it.
What are the advantages and disadvantages of the payback method?
-The advantages of the payback method are that it is easy to understand, it adjusts for uncertainty of later cash flows, and it is biased towards liquidity, which frees up cash for other uses more quickly.
-The disadvantages of the payaback method are that it ignores the time value of money, it requires an arbitrary cutoff point, it ignores cash flow beyond the cutoff date, and it is biased against long-term projects, such as R&D, and new projects.
What are the advantages and disadvantages of AARR?
-The advantages of AARR are that it is easy to calculate, and that the information we need is usually available.
-The disadvantages of AARR are that it’s not a true rate of return, the time value of money is ignored, it uses an arbitrary benchmark cutoff rate, and that it is based on accounting book values, as opposed to cash flows and market values.
What are the advantage of NPV?
-The advantage of NPV is that the result of the computations of NPV of all projects can be added to understand how much we generate from a range of projects.
-The NPV also allows for various rate of returns over the life of the project.
What are the advantages and disadvantages of IRR?
-The advantages of IRR are that it is easy to communicate and understand, and it is closely related to NPV, leading to nearly identical decisions.
-The disadvantage of IRR is that the computation is a percentage, which can’t be added or averaged to derive the IRR of the combination of projects.
-The IRR may also result in multiple answers or no answer with non-conventional cash flows.
-The IRR may lead to incorrect decision making in comparisons of mutually exclusive investments.
