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CPA > CPA BEC Flashcards > -Capital Budgeting > Flashcards

-Capital Budgeting Flashcards

1
Q

What is Capital Budgeting? How is it used?

A

Capital Budgeting is a managerial accounting technique that:

  • evaluates different investment options
  • Helps management make decisions
  • uses both accounting and non-accounting information.

With this technique, the focus is internal and GAAP is not mandatory.

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2
Q

What values are used in Capital Budgeting?

A

Capital Budgeting ONLY uses Present Value tables. It NEVER uses Fair Value.

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3
Q

When is the Present Value of $1 table used?

A

For ONE payment - ONE time

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4
Q

When is the Present Value of an Annuity Due used?

A

The Present Value of an Annuity Due is used on multiple payments made over time—where the payments are made at the START of the period.

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5
Q

When is the Present Value of an Ordinary Annuity of $1 (PVOA) used?

A

The Present Value of an Ordinary Annuity of $1 is used on multiple payments over time—where payments are made at the END of the period.

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Think A for Arrears.

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6
Q

What is the calculation for the Present Value of $1?

A

(1 / ( 1+i )^n)

i = interest rate

n = number of periods

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7
Q

What is Net Present Value (NPV)?

A

NPV is a preferred method of evaluating profitability.

It is one of the two methods that use the Time Value of Money:

PV of Future Cash Flows - Investment

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8
Q

How is NPV used to calculate future benefit?

A

NPV: PV Future Cash Flows - Investment

  • If NPV is Negative - cost is greater than benefits (bad investment)
  • If NPV is Positive - cost is less than benefit (good investment)
  • If NPV = 0, then Cost = Benefit (Management is indifferent)

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9
Q

What is the rate of return on an investment called?

A

The Discount Rate

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10
Q

What does the Discount Rate represent?

A

The Discount Rate is the rate of return on an investment used. It represents the minimum rate of return required.

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11
Q

What are the strengths of the Net Present Value system?

A

Net Present Value uses:

  • Time Value of Money
  • all cash flows; not just the cash flows to arrive at Payback; and
  • takes risks into consideration

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12
Q

What are the weaknesses of the Net Present Value system?

A

The NPV system is NOT as simple as the Accounting Rate of Return.

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13
Q

How do Salvage Value and Depreciation affect Net Present Value?

A

NPV includes Salvage Value because it is a future cash inflow.

NPV does NOT include depreciation because it is non-cash.

Exception: If a CPA Exam question says to include tax considerations, then you have to include depreciation because of income tax savings generated by depreciation.

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14
Q

If multiple potential rates of return are available, which is used to calculate Net Present Value?

A

The minimum rate of return is used.

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15
Q

What is the Internal Rate of Return (IRR)?

A

The IRR calculates a project’s actual rate of return through the project’s expected cash flows.

It is the rate of return required for PV of future cash flows to EQUAL the investment.

Investment / After-Tax Annual Cash Inflow = PV Factor

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16
Q

Which rate of return is used to reinvest cash flows for Internal Rate of Return?

A

Cash flows are reinvested at the rate of return earned by the original investment.

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17
Q

How does the rate used for Internal Rate of Return (IRR) compare to that used for Net Present Value (NPV)?

A

Rate of return for IRR is the rate earned by the investment.

Rate of return for NPV is the minimum rate.

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18
Q

What are the strengths and weaknesses of the Internal Rate of Return system?

A

Strengths: Uses Time Value of Money - Cash Flow emphasis

Weakness: Uneven cash flows lead to varied IRR

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19
Q

When is NPV on an Investment positive?

A

The NPV is positive on an investment when:

  • Benefits are greater than the costs
  • IRR is greater than the Discount Rate

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20
Q

When is NPV on an Investment Negative?

A

The NPV is negative on an investment when:

  • Costs are greater than Benefits
  • IRR is less than the Discount Rate

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21
Q

When is NPV Zero?

A

NPV is Zero when:

  • Benefits equal the Costs
  • IRR = Discount Rate

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22
Q

What is the Payback Method? How is it calculated?

A

The Payback Method measures an investment in terms of how long it takes to recoup the initial investment via Annual Cash Inflow.

Investment / Annual Cash Inflow : Payback Method

Compare to a targeted timeframe:

  • If payback is shorter than target, it’s a good investment.
  • If payback is longer than target, it’s a bad investment.

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23
Q

What are the strengths of the Payback Method?

A

The Payback Method takes risk into consideration.

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Two-year payback is less risky than a five-year payback

24
Q

What are the weaknesses of the payback method?

A

The Payback Method ignores the Time Value of Money. Exception: Discount payback method.

It ignores cash flow after the initial investment is paid back.

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25
Q

What is the Accounting Rate of Return?

A

The Accounting Rate of Return is an approximate rate of return on assets.

ARR: Net Income / Average Investment

Compare to a targeted return rate:

  • if ARR is greater than target - good investment.
  • If ARR less than target - bad investment.

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26
Q

What are the strengths of the Accounting Rate of Return (ARR)?

A

ARR is:

  • Simple to use
  • Easy to understand

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27
Q

What are the weaknesses of the Accounting Rate of Return (ARR)?

A

ARR:

  • Can be skewed based on Depreciation method
  • Ignores Time Value of Money

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28
Q

What is an Expected Return?

A

An Expected Return is an approximate rate of return on assets.

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CPA BEC Flashcards (9 decks)

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