Week 13 Capital Budgeting Flashcards
is the process of planning and evaluating investments in plant assets (equipment and machinery)
capital budgeting
- equipment purchase decision
- equipment replacement decisions
- lease v. buy decisions
- plant expansion decisions
typical capital budgeting decisions
- net present value (NPV) method
- internal rate of return (IRR) method
- payback period
- accounting rate of return method (ARR)
four capital budgeting techniques
if the Net present value is positive then the project is
acceptable, since it promises a return greater than the minimum required rate of return (cost of capital)
if the Net present value is zero, then the project is
acceptable, since it promises a return equal to the minimum required rate of return (cost of capital)
if the Net present value is negative, then the project is
not acceptable, since it promises a return less than the minimum required rate of return (cost of capital)
represents the smallest rate of return the company is willing to accept on its investment projects
cost of capital
- use the cost of capital to find the present values of the cash flows
- minimum required rate of return
- discount rate
- hurdle rate
cost of capital can be referred to as
- initial investment
- working capital investment
- increase in variable costs
- repairs, maintenance, and overhauls
typical cash outflows
- increase in revenues
- reduction of costs
- salvage value
- release of working capital
typical cash inflows
is not included in calculating the net present value of a project because IT IS NOT A CASH OUTFLOW
depreciation
represents the actual or real rate of return generated by an investment project
internal rate of return (IRR)
if the Internal rate of return is equal to or greater than the minimum required rate of return (cost of capital), therefore the NPV > 0 or = 0, then the project is
acceptable
if the Internal rate of return is less than the minimum required rate of return (cost of capital), therefore the NPV < 0 then the project is
rejected
represents the length of time it will take for a project to pay for itself
payback period
- The payback period formula is the same as what formula
- So the payback period is the same as
- IRR factor formula
- IRR factor
- it ignores the time value of money
- it ignores all information that occurs after the payback period has been reached
disadvantages of payback method
- ignores the time value of money
- should not be the basis on which a decision is made
- Can be used as a way to narrow the choices down to a reasonable number
Payback period and
accounting rate of return
when the cash flows associated with an investment project change from year to year, the payback formula introduced earlier cannot be used
the un-recovered investment must be tracked year by year
does not focus on cash flows - rather it focuses on accounting net income
accounting rate of return (ARR)
a cash flow Net of its income tax effect
after tax cash flow
What cash outlflows after tax are the exact same and you just multiple by 1
- initial investment
- working capital needed now
What cash outflows after tax value is the outflow multiplies by (1 - tax rate)
- increase in costs
- repairs, maintenance, overhauls
why is there no tax effect on the initial investment
the initial investment does not effect revenues or expenses thus it does not effect the taxes owed by a company. the intitla investment is simply giving up cash (an asset) to purchase another asset (equipment; machinery)
- the same logic can be applied to the working capital which is why there is no tax effect on it as well
