ACC 350 | Chapter 26
What is Capital Budgeting?
-Capital budgeting is plannng to invest in capital assets in a way that returns the moost profitability to the company
Caliber Lawnmowers is considering the purchase of a new machine costing $804,000. The company's management is estimating that the new machine will generate additional cash flows of $180,000 a year for ten years and have a residual value of $62,000 at the end of ten years. What is the machine's payback period? (Round your answer to two decimal places.)
4.47 years
Accounting Rate of Return (ARR)
A capital investment analysis method that measures the profitability of an investment. Average annual operating income / Average amount invested. *uses operating income rather than cash flows *Decision Rue: if the expected ARR meets or exceeds the required rate of return, invest in the asset
Which of the following describes the time value of money?
A dollar received today is worth more than a dollar to be received in the future.
What is the second step of capital budgeting?
B. Identifyig potential projects
Which method does not consider the investment's profitability of the following options? A. ARR B. Payback C. NPV D. IRR
B. Payback
Profitability Index
Computes the number of dollars returned for every dollar invested, with all calculations performed in present value dollars. The present value of net cash inflows / Initial investment.
which affects the PV of an investment A. type of investment (annuity v. lump sum) B. # of time periods (length of investmetn) C. the interest rate D. all the above
D. all the above
The capital budgeting process involves the following steps:
Develop strategies, plan, act, control
Both the payback and the accounting rate of return methods focus on cash flows that an asset generates.
FALSE
When the internal rate of return is the same as the required rate of return, the net present value of an investment will be positive.
FALSE
Managers generally use payback as the sole method for deciding whether to invest in an asset.
False
Criticism of Payback Method
Focuses is on time--not profitability Ignores cash flows after payback period
Cash Outflows include
Initial investment (acquisition cost) Additional operating costs Refurbishment, repairs, and maintenance
which is the most reliable method of making capital budgeting decisions
NPV method
NPV
Net Present Value - the difference between the present value of cash inflows and the present value of the investment's net cash inflows and the investment's costs.
Capital budgeting decisions typically require large invesments and affect ________ for several years
Operations
Your rich aunt is giving you 2,000 a year for 4 years. Using a discount rate of 12% the PV of the gift can be stated as
PV = 2000 ( annuinity PV factor, i=12, n=4)
Lora Corporation will receive $10,000 a year at the end of each of the next five years. Using a discount rate of 14%, the present value of the receipts can be stated as ________.
PV = $10,000 (Ordinary Annuity PV factor, i = 14%, n = 5)
Zane Set Designs Company has received an award which entitles it to receive annual payments of $10,000 at the end of each year for the next ten years. Which of the following is used to calculate today's value of this award?
Present Value of an Ordinary Annuity of $1
Net present value represents the difference between the ________.
Present value of the investment's net cash inflows and the investment's initial cost
Cash flows include
Revenue generated from the investment Savings in operating costs Residual Value
-Capital Assets are long-term, operational Assets
TRUE
An opportunity cost is the benefit foregone by choosing an alternative course of action.
TRUE
A post-audit in capital budgeting is a comparison of the actual results of capital investments with the projected results.
TRUE
Net cash inflows from a capital investment arise from an increase in revenues, a decrease in expenses, or both.
TRUE
The Accounting Rate of Return method evaluates the lifetime return of an investment, whereas Return on Investment evaluates the annual return of an investment.
TRUE
The accounting rate of return also is known as the average rate of return or annual rate of return.
TRUE
The accounting rate of return is calculated by dividing the average annual operating income by the average amount invested.
TRUE
The accounting rate of return shows the effect of the investment on the company's accrual-based income.
TRUE
The discounted cash flow methods of evaluating capital investments are superior because they consider both the time value of money and the profitability of the investment.
TRUE
The fact that invested cash earns income over time is called the time value of money.
TRUE
The internal rate of return (IRR) is the rate of return, based on discounted cash flows, of a capital investment.
TRUE
The net present value of future cash inflows received in earlier years is higher than future cash inflows received in later years.
TRUE
The only difference between the present value and future value of a lump sum is the amount of interest that is earned in the intervening time span.
TRUE
The payback and accounting rate of return methods are often used to perform an initial screening of investments.
TRUE
The payback method provides management with valuable information about the time period in which the cash invested will be recouped.
TRUE
Which of the following situations suggests the acceptance of an investment proposal?
The present value of the net cash inflows exceeds the initial investment.
An operational asset used for a long period of time is known as a capital asset.
True
The accounting rate of return is calculated by dividing the average annual operating income by the average amount invested.
True
The fact that invested cash earns income over time is called the time value of money.
True
Payback
a capital investment analysis method that measures the length of time it takes to recover, in net cash inflows, the cost of the initial investment = Amount Invested/ expected annual cash inflow
Which of the following best describes the term capital rationing?
a process of ranking and choosing among alternative capital investments based on the availability of funds
Which of the following most accurately describes an annuity?
a stream of equal cash payments made at equal time intervals
Which of the following is a capital budgeting method used to screen potential investments?
accounting rate of return
Sensativity analysis
allows managers to evaluate differences when underlying assumptions change
NPV
analysis is a capital investment analysis method that measure the net differences between the PV and the investment's net cash inflows and the investment's costs
Internal Rate of Return
based on discounted cash flows of a capital investment, it is the interest rate taht makes the NPV of the investment equal to zero *if IRR meets or exceeds the required rate of return, invest
-Capital investments are acquisitions of _____ ________
capital assets
Capital budgeting has a focus on ______ ______
cash flows
Protitability Index
computes the numbers of dollars returned for every dollar invested, with all calculations perfromed in PV dollars. It is useful to rank projcects in differenct sizes
in computing the IRR a company should consider
depreciation on the assets built int he company's expaniseon
When comparing several investments with the same initial cost, the decision should be made on the basis of the ________.
highest NPV
Discounted Cash Flow Methods
incorporate compound interest and make comparisons by converting all cash flows to the same point in time--aka the PV
At the internal rate of return, the present value of net cash inflows will equal the ________.
initial cost of the investment
Which of the following best describes the internal rate of return?
interest rate that makes the net present value of the investment equal to zero
Which of the following is the rate of return, based on discounted cash flows, a company can expect to earn by investing in a capital asset?
internal rate of return
Decision Rule- Payback
investment with SHORTER payback periods are more desirable, all else being equal
Discount Rate
is managmenet's minimum desired rate of return on a capital investment and is used to selevet the PV facotrs used when calculating the NPV of a procjet *if NPV is positive, invest
Capital Rationing
is the process of ranking and choosing among alternative capital investments based on the availability of funds.
IRR
is the rate of return based on discounted cash flows, of a capitla investment. It is the interest rate that amkes the NPV of the invsest equal to zero
Compound interest
means that interest is calculated on the principal and on all previously earned interest
Simple interest
means that interst is calculated only on the principal amount
Reagrding Capital rationing investments companies should
not choose the highest NPV, ARR of payback--must think
Caital rationing
occures when funds for capital investments are limited *qualitative and quantitative factors should be considered
Lump Sum Payment
one-time cash payment PV Caclculation for Lump sum PV = future cvalue x PV facotr for i=?, n=?
Capital budgeting is the ________.
process of planning for investments in long-term assets
The discount rate used in a net present value analysis is the ________.
required rate of return or the hurdle rate
Sensitivity analysis is a technique that ________.
shows how results differ when underlying assumptions change
Annuities
streams of equal cash payments made at equal time intervals PV calculation for annuity PV= amount of each cash inflow x annuity PV factor for i=?, n=?
Ian Corp. is considering two expansion projects. The first project streamlines the company's warehousing facilities. The second project automates inventory utilizing bar code scanners. Both projects generate postivie NPV, yet Ian Corp. only chooses the bar coding project. Why? A. The IRR of the warehousing project is less than the company's required rate of return for capital projects. B. The company is practicing capital rationing. C. The payback is greater than the warehouse project's life. D. All of the above are true.
the company is practicing capital rationing
Time value of money
the fact that money can be invested to earn income over time *explains why we'd want money now rather than later
When projecting future cash flows of an investment ________.
the initial investment is a significant cash outflow that is treated separately from all other cash flows
the IRR is
the interest rate at which NPV of the investment is zero
discount rate
the minimum desired rate of return on a capital investment and is used to select the PV factors used when calculating the net PV of a project *if positive invest in the capital asset
Software Hub is deciding whether to purchase new accounting software. The cost of the software package is $68,000, and its expected life is ten years. The payback for this investment is four years. Assuming equal yearly cash flows, what are the expected annual net cash savings from the new software? (Assume the investment has no residual value.)
$17,000
Software Hub is deciding whether to purchase new accounting software. The cost of the software package is $68,000, and its expected life is ten years. The payback for this investment is four years. Assuming equal yearly cash flows, what are the expected annual net cash savings from the new software? (Assume the investment has no residual value.)
$17,000 | **68,000 / 4 = $17,000
