Chapter 14 The Basics of Capital Budgeting Flashcards
(43 cards)
What are Capital Budgeting decisions?
What is another term for this?
Decisions involving the listing of all capital investments (projects) to be undertaken in the future.
The process of selecting a business’s capital (long-term asset) investments.
Long-term (fixed) asset acquisition decisions involving expenditure of capital funds.
Issue if too little is invested in fixed assets?
technological obsolescence and inadequate capacity
What are the 5 Project Classifications
Category 1 Mandatory replacement
Category 2 Discretionary replacement
Category 3 Expansion of existing services or markets
Category 4 Expansion into new services or markets
Category 5 Environmental projects
What are the four steps of capital budgeting financial analysis?
- estimate the expected cash flows (most critical and difficult step)
- initial cash outlay (cost)
- operating flows
- terminal (ending) flow - assess the riskiness of those flows (project’s riskiness)
- estimate the appropriate cost-of-capital discount rate (opportunity cost of capital or discount rate)
- determine the project’s profitability and breakeven characteristics. (measure the financial impact).
What is the most critical and most difficult step in analyzing a project?
Estimating the incremental can flows that the project will generate
What is capital budgeting?
the process of analyzing potential expenditures on fixed assets and deciding whether the firm should undertake those investments. (Forecasting costs is best for lowest possible financing costs and availability of funds as they are needed).
What should be considered in incremental cash flows?
Opportunity costs (the cashflows forgone by using an asset) and Other projects (impacted by "the project")
-sunk costs (cash outlays that cannot be recouped) are not included
What are tax laws?
How do tax laws affect investor owned firms (3 ways).
Tax laws are Tax laws are the legal rules and procedures governing how federal, state and local governments calculate the tax you owe.
Taxes 1) Reduce a project’s operating cash flows
2) tax laws prescribe depreciation expense that can be taken in any year
3) Taxes affect a project’s salvage value cash flow
What might a project have that is not accounted for in the estimated cash flows?
Strategic value ( at a minimum, strategic value should be noted and considered qualitatively in the analysis)
What changes are required in Capital Projects when there are additional investments added in fixed assets ?
What do the changes represent and where is it included?
Changes in current accounts in addition to the investment in fixed assets.
The changes represent a cash flow that must be included in the analysis .
What should be considered in project analyses and what is the best procedure?
The effects of inflation should be considered. The best procedure is to build inflation effects directly into the component cash flow estimates.
What is time breakeven and what is it measured by? What insights does time breakeven provide to managers?
Time breakeven is measured by payback period and provides managers with insights concerning a project’s liquidity and risk.
What is project profitability assessed by?
ROI Return on Investment measures. (most common) Net Present Value and Internal Rate of Return
What is Net Present Value and what does it do?
NPV - the sum of the present values of all the project’s net cash flows when discounted at the project’s cost pf capital.
It measures a project’s expected dollar profitability.
What does a NPV greater than 0 indicate?
the project is expected to be profitable after all costs including the opportunity cost of capital. The higher the NPA the more profitable the project
Internal Rate of Return (IRR)
what does it measure?
The discount rate that forces a project’s SPV to equal zero.
It measures a project’s expected rate of return. (If a project’s IRR is greater than its cost of capital, the project is expected to be profitable. the higher the IRR the more profitable the project.
What do the NPV and IRR profitability measures provide?
Measures provide identical indications of profitability, a project that is judged to be profitable by its NPV will also be judged profitable by its IRR.
When mutually exclusive projects are being evaluated, how might a NPV rank differently (higher) than IRR?
This difference can occur because the two measures have different reinvestment rate assumptions. IRR assumes that cash flows can be reinvested at the project’s IRR. NPV assumes that cash flows can be reinvested at the projects’s cost of capital.
What is modified internal rate of return (MIRR)
forces a projects cash flows to be reinvested at the projects cost of capital and is a better measure of a project’s percentage rate of return than the IRR
What is the Net Present Social Value (NPSV) Model
formalizes the capital budgeting decision process for not-for -profit firms.
What do firms use to subjectively incorporate a large number of factors including financial and nonfinancial, into the capital budgeting decisions process
project scoring
what is a key element in capital budgeting? (comparing actual results with predicted results, managers can improve both operations and the cash flow estimation process)
post-audit
capital budgeting techniques, what are they used for?
used for a wide variety of settings in addition to project evaluation.
Capital budgeting decisions
the process of selecting a business’s capital (long-term assets) investments. The list of investments chosen constitutes a business’s capital budget.
