making capital investment decisions Flashcards
(33 cards)
What are the measures used to compare and select different investments?
- Payback Rule
- Discounted Payback
- Average Accounting Return (AAR)
- Internal Rate of Return (IRR)
- Profitability Index (PI)
- Net Present Value (NPV)
Why is NPV the most used measure for capital budgeting?
It includes information from all other measures and is more flexible.
What is the focus when estimating cash flows in capital budgeting?
Incremental cash flows.
Define Incremental Cash Flow (ICF).
The difference between a firm’s future cash flows with a project and those without the project.
What costs and cash flows are considered when calculating ICF?
Only relevant costs and cash flows that come directly as a result of the project.
What are Sunk Costs?
Costs already paid and cannot be retrieved.
What are Opportunity Costs?
Giving up a benefit or opportunity.
What are Side Effects in project cash flows?
- Erosion: New product reduces cash flows of existing products
- Synergy: New project increases cash flows of existing projects.
What is Net Working Capital (NWC)?
The difference in a firm’s current assets and current liabilities.
What are Financing Costs?
Costs arising from financing the project.
What is the formula for Project Cash Flows?
Project Cash Flow = Project Operating Cash Flows - Project Capital Spending.
How is Operating Cash Flow (OCF) calculated?
OCF = Net Income + Depreciation - Increase (+Decrease) in Net Working Capital.
What is the formula for Net Income (NI)?
NI = (Sales - Variable Cost - Fixed Cost - Depreciation)*(1 - Taxes).
What is the required rate of return (k) in capital budgeting?
The minimum return that an investment must earn to be considered worthwhile.
Calculate the Net Income (NI) given sales of £200,000, variable costs of £125,000, fixed costs of £12,000, depreciation of £30,000, and taxes of 34%.
NI = £21,780.
What is the Operating Cash Flow (OCF) if Net Income is £21,780 and depreciation is £30,000?
OCF = £51,780.
What is the formula for calculating NPV?
NPV = Present Value of Cash Flows - Initial Investment.
What is Straight-Line Depreciation?
A method that allows for a linear write-off of assets over their lifetime.
What is Reducing-Balance Depreciation?
A method that allows for the accelerated write-off of assets under various classifications.
What are the main capital budgeting steps?
- Determine the depreciation schedule of the assets
- Calculate the net income arising from the project
- Estimate operating cash flows
- Carry out the cash flow analysis.
What is the Bottom-Up Approach in OCF calculation?
Start from net income and add back the depreciation.
What is the Top-Down Approach in OCF calculation?
Start from sales and work down to costs and taxes.
What is the Tax Shield Approach?
OCF = (Sales - Costs)(1-T) + DepreciationT.
True or False: The method used to calculate OCF will affect its final value.
False.
