Unit 13: Investment Decisions Flashcards
What is capital budgeting?
Capital budgeting is the process of identifying, analyzing, and selecting investments in long-term projects. It is this long-term aspect of capital budgeting that presents the management accountant with specific challenges. By their nature, capital projects affect multiple accounting periods and will constrain the organization’s financial planning well into the future. Once made, capital budgeting decisions tend to be relatively inflexible, unless real options exist.
Describe a sunk cost.
A sunk cost cannot be avoided because it occurred in the past. A sunk cost is irrelevant because it has already been incurred and cannot be changed.
Describe an opportunity cost.
An opportunity cost is the maximum benefit forgone by using a scarce resource for a given purpose and not for the next-best alternative.
What is a depreciation tax shield?
A depreciation tax shield is the amount by which depreciation shields or protects the taxpayer from income taxes.
Depreciation expense × Tax rate
What is a hurdle rate?
A firm’s hurdle rate is the minimum rate of return on a project or investment that an investor is willing to accept.
Describe abandonment of a project.
Abandonment is a real option to modify the capital investment. Abandonment of a project entails selling its assets or employing them in an alternative project. Abandonment should occur when, as a result of an ongoing evaluation process, the entity determines that the abandonment value of a new or existing project exceeds the NPV of the project’s future cash flows.
How is sensitivity analysis used to analyze the risk of a capital investment?
Sensitivity analysis is the process of comparing the forecasts of many calculated net present values (NPVs) under various assumptions to see how sensitive NPV is to changing conditions. Changing the assumptions about a certain variable or group of variables may drastically alter the NPV. Thus, the asset may appear to be much riskier than originally predicted.
What is a real option?
Real options are options to modify the capital investment. Real options are not measurable with the same accuracy as financial options because the formulas applicable to financial options may not be appropriate for real options. Some examples of real options are (1) abandonment, (2) option to delay, and (3) option to expand.
Describe risk tolerance.
Risk tolerance is the acceptable degree of variability in returns. A company with a high risk tolerance is willing to risk big losses for the chance at big gains. A company with a low risk tolerance will avoid seeking big gains in order to avoid the possibility of big losses.
What is the present value of a single amount?
The present value (PV) of a single amount is the value today of some future payment. It equals the future payment times the present value of 1 (a factor found in a standard table) for the given number of periods and interest rate.
What is an annuity?
An annuity is usually a series of equal payments at equal intervals of time, e.g., $1,000 at the end of every year for 10 years.
Describe the difference between an ordinary annuity and an annuity due.
An ordinary annuity is a series of payments occurring at the end of each period. The first payment of an ordinary annuity is discounted.
An annuity due is a series of payments at the beginning of each period. The first payment of an annuity due is not discounted.
Describe the net present value method.
The net present value (NPV) method expresses a project’s return in dollar terms. NPV nets the expected cash flows (inflows and outflows) related to a project, then discounts them at the hurdle rate, also called the desired rate of return. If the NPV of a project is positive, the project is desirable because it has a higher rate of return than the company’s desired rate.
Describe the internal rate of return.
The internal rate of return (IRR) expresses a project’s return in percentage terms. The IRR of an investment is the discount rate at which the investment’s NPV equals zero. In other words, it is the rate that makes the present value of the expected cash inflows equal the present value of the expected cash outflows.
What are some of the disadvantages or limitations of using the internal rate of return (IRR) method?
IRR used in isolation is seldom the best route to a sound capital budgeting decision. The following factors reduce the usefulness of IRR:
Direction of cash flows. When the direction of the cash flows changes from period to period, focusing on IRR can be misleading.
Mutually exclusive projects. As with changing cash flow directions, focusing only on IRR when capital is limited can lead to unsound decisions.
Varying rates of return. A project’s NPV can easily be determined using different desired rates of return for different periods. The IRR is limited to a single summary rate for the entire project.
Multiple investments. NPV amounts from different projects can be added, but IRR rates cannot. The IRR for the whole is not the sum of the IRRs for the parts.
Assumed reinvestment rate. NPV assumes the cash flows from the investment can be reinvested at the project’s discount rate, that is, the desired rate of return (generally, the company’s cost of capital rate), while the IRR assumes that reinvestments can earn the IRR initially calculated.
