Chapter 21: Capital Budgeting and Cost Analysis Flashcards
What are the 4 capital budgeting methods used to analyze financial information?
- Net present value (NPV)
- Internal rate of return (IRR)
- Payback
- Accrual accounting rate of return (AARR)
What is the Net Present Value Method?
What is the decision rule for this method?
Calculates the expected gain or loss from a project by discounting all expected future cash inflows/outflows back to the present using the required rate of return.
Projects with a 0 or positive NPV are accepted.
Payback Method
What is the decision rule for this method?
Measures the time it will take to recoup, in the form of expected future cash flows, the net initial investement in a project.
Magement choose a cutoff period that is acceptable and if project fall within that period it is accepted.
What are 2 weaknesses of the Payback Method?
- Does not consider time value of money
- Does not consider cash flow beyond payback period
What is classified as cash flow from operations?
- After-tax cash flow (excluding depreciation)
- Cash savings from depreciation tax deduction
- After-tax cash flow from terminal disposal excluding gains/losses, but including tax savings
What are the 3 categories of cash flows?
- Net initial investment
- After-tax cash flow from operations
- After-tax cash flow from asset disposal
What does modern risk management suggest in regards to high risk projects?
Shorter cutoff periods for riskier projects.
Calculate the Return on Investment.
Income
divided by
Invested capital
or
Return on Sales times Asset Turnover
or
Income divided by sales
times
Sales divided by Invested Capital
How do you calculate the average investment?
Net Intial Investment + Net Terminal Cash Flow
divided by
2
Capital budgeting
Process of making long-run planning decisions for investment in projects
What are relevant cash flows?
How do they relate to Discounted Cash Flow analysis?
The differences in expected future cash flows as a result of making an investment.
When making decisions among projects you should only consider relevant cash flows.
Discounted Cash Flow (DCF) Method
Measures all expected future cash inflows and outflows of a project discounted back to the present.
Internal Rate-of-Return (IRR) Method
What is the decision rule for this method?
Calculates the discount rate at which an investment’s present value of all expected cash inflows equal the present value of its expected cash outflows.
or
The discount rate that makes NPV = $0
Accept a project only if the IRR is greater than the required rate of return.
What are the benefit sof a short payback period?
These projects are more liquid and gives a company more flexibility with funds for other projects.
