9: Financial Management, Capital Budgeting Flashcards Preview

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Flashcards in 9: Financial Management, Capital Budgeting Deck (23)
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1
Q

what is capital budgeting

A

the process of measuring, evaluating, and selecting long term investment opportunities for a firm

2
Q

capital undertakings have elements of both risk and reward. define those

A

risk: the possibility of loss or other unfavorable results that derives from uncertainty implicit in future outcomes
reward: benefit expected or required from investment of resources in capital projects and other undertakings

the relationship is the greater the received risk, the greater expected reward. reward is perceived risk

3
Q

what is risk free rate

A

it is to compensate lenders for determining use of funds by making an investment, does not change with perceived risk.

4
Q

what is the payback period approach

A

determines the number of years needed to recover the initial cash investment in a project and compares that time with the preestablished maximum payback period
if payback period

5
Q

what is the payback calculation

A

Payback = investment cost/annual cash savings

6
Q

what are the advantages of payback period approach

A

easy to use, useful in evaluating project liquidity

7
Q

what are the disadvantages of payback period approach

A

ignores time value of money, ignores cash flows after payback period, does not measure total project profitability

8
Q

what is the discounted payback period approach

A

determines the number of years needed to recover the initial cash investment in a project using discounted cash flows and compares that time with a pre-established maximum payback period.
if payback period

9
Q

what are the advantages of discounted payback period approach

A

easy to use, useful in evaluating project liquidity, uses time value of money concept

10
Q

what are the disadvantages of discounted payback period approach

A

ignores cash flows after payback period, does not measure total project profitability

11
Q

what is the accounting rate of return approach

A

determines the expected annual incremental accounting net income from a project as a percentage of the initial or average investment
ARR= (average annual incremental revenue-average annual incremental exp)/initial or average investment
if ARR > preestablished rate=accept

12
Q

what are the advantages of ARR

A

easy to use, consistent with financial statement values, considers entire life and results of project

13
Q

what are the disadvantages of ARR

A

ignores time value of money, uses accrual accounting values, not cashflows, assumes the incremental net income is the same each year

14
Q

what is net present value approach

A

difference between present value of cash inflows and outflows. determined using a discounted rate called a hurdle rate based on cost of capital to the firm

15
Q

what are the advantages of npv approach

A

recognizes time value of money, relates project rate of return to cost of capital, considers the entire life, provides for compounding of amounts over time.

16
Q

what are the disadvantages of npv approach

A

requires the estimation of cashflows over the entire life of the project, assumes cashflows are immediately reinvested at the discount rate of return used

17
Q

what is the IRR approach

A

determines what rate of return makes the npv of net cashflows equal to zero.

18
Q

PV factor

A

PV factor=investment cost/future annual cash inflows

19
Q

what are the advantages of IRR

A

recognizes time value of money, considers entire life of project

20
Q

what are the disadvantages of IRR

A

difficult to compute, requires estimation of cash flows over entire life of project, assumes cash flows are immediately reinvested at internal rate of return

21
Q

when is project economically feasible

A

what it has a positive net present value

22
Q

what is the profitaility index

A

determines project rankings by taking into account both the npv and cost of each project
higher the percentage, the higher the rank

23
Q

profitability index calculation

A

npv of project inflows/pv of project cost