L2 - Adv Cap Budgeting Flashcards
(21 cards)
What is the main principle behind budgeting decisions?
Decisions are based on cash flows, considering their timing, incrementality, and after-tax basis, while ignoring financing costs
Define opportunity cost and how its relevant in capital budgeting
The potential earnings from the next-best use of an asset and should be considered as a relevant cash flow
What is an incremental cash flow?
The difference in a company’s cash flows with and without the project
Differentiate between independent and mutually exclusive projects
Independent: Accepting one doesn’t preclude others
Mutually exclusive: Accepting one precludes others
What is capital rationing and its potential consequence?
A limit on capital expenditure for projects, potentially leading to the rejection of profitable projects
Why are cash flows preferred over accounting earnings in capital budgeting?
Cash flows represent actual spendable money, unlike earnings which can be manipulated and are not directly available for reinvestment
Advantages of NPV?
- Cash flow based
- Uses all cash flows
- TVM
- Linked to value maximisation
Limitations of NPV?
- Absolute criterion (no consideration of scale)
- Can be biased towards longer term projects when comparing mutually exclusive projects
Disadvantages of Payback period?
- Ignores CFs after payback
- No TVM
What is Average Accounting Return?
Avg return / avg investment
AAR Disadvantages?
- Uses book values
- No discounting
- Targeted rate of return is arbitrary
What is the IRR decision rule?
If IRR > Cost of capital … accept`
Describe the multiple IRR problem:
When cash flows change sign more than once there may be multiple IRRs, use NPV instead
How does the NPV profile relate to IRR?
The NPV profile shows the sensitivity of NPV to discount rates, crossing the x-axis at the IRR
Why might a company prefer IRR over NPV?
- Limited access to capital
- Stream of surplus value projects
- Faces more uncertainty in its cash flows
Why might a company prefer NPV over IRR?
- Substantial funds on hand
- access to capital
- limited surplus value projects
- more certainty on its project cash flows
Explain the reinvestment rate assumptions of NPV and IRR
NPV assumes reinvestment at the hurdle rate ; IRR assumes reinvestment at the IRR
What is the MIRR
Discount rate which sets PV of costs to the PV of the terminal value, where TV is found by compounding inflows at WACC
What reinvestment rate does MIRR assume?
WACC
Define Profitability Index (PI)
PV of future cash flows divided by the initial investment
What is the PI decision rule?
If PI > 1 accept
