Chapter 13 Terms

Equal

When making a preference decision, the net present value of one project cannot be directly compared to the net present value of another project unless the initial investments are _____.

Investment, Inflow

When the annual net cash inflow is the same each year, the payback period equals the ___________ required divided by the annual net cash ______.

Higher

When using the project profitability index to rank competing investments, the ______ the project profitability index, the more desirable the project.

Annuity

A(n) _______ is a series of equal cash flows.

If the NPV is zero....

Acceptable because its return is equal to the required rate of return

If the NPV is positive....

Acceptable because its return is greater than the required rate of return

What assumption underlies net present value analysis?

All cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate.

Simple Rate of Return equation

Annual Incremental NOI/Initial Investment

Tax Shield

Because a depreciation deduction reduces taxable income, it is referred to as a depreciation

Preferences Decision

Relate to selecting from among several acceptable alternatives.

2 Categories of Capital Budgeting Decision

Screening Decision and Prefernce Decision

Accounting, Unadjusted

Synonyms for the simple rate of return are the _________ rate of return and the __________ rate of return.

Quickly

The basic premise of the payback method is that the more _______ the cost of an investment can be recovered, the more desirable the investment is.

Annual Incremental NOI equation

- Annual Incremental Rev - annual incremental cash operating expenses - annual depreciation

Which of the following are not typical capital budgeting cash outflows:

- Cost reduction - Salvage value of old equipment

Discounting

- Finding the present value of a future cash flow is called: - Calculating the present value of money is referred to as ___________ cash flows.

Which of the following are the most common measurements used to rank acceptable investment projects?

- Internal rate of return - Project profitability index

Which of the following are true regarding the time value of money?

- Projects that provide earlier returns are preferable to those that promise later returns. - By collecting a project's return quickly, the investor has the opportunity to re-invest that money to earn even more.

Which of the following are appropriately classified as capital budgeting decisions?

- Purchasing new equipment to reduce cost - Acquiring a new facility to increase capacity - Choosing to lease or buy new equipment - Determining which equipment to purchase among available alternatives - Deciding to replace old equipment

Match each capital investment cash flow with the appropriate category.

- Salvage value: Inflow - Initial investment: Outflow - Working capital: Inflow and outflow

Match the following categories of capital budgeting decisions with their description.

- Screening decisions: Relate to whether a proposed project is acceptable. - Preference decisions: Relate to selecting from among several acceptable alternatives.

True

- The cost of capital may be used to screen out undesirable projects. - When using the internal rate of return method, the cost of capital is used as the hurdle rate. - - When the net present value method is used, the discount rate equals the hurdle rate.

Salvage

- The investment value used in the payback period calculation when new equipment is being considered should be the cost of the new equipment net of any ________ value from the old equipment being replaced. - When using the simple rate of return, the initial investment should be reduced by the _______ value of old equipment.

Which of the following statements are true?

- The more frequently interest is compounded, the faster the balance grows. - Compound interest means that the interest is paid on interest.

Select all correct statements regarding net present value:

- The net present value method automatically provides for return of the original investment. - A project with a positive NPV will recover the original cost of the investment plus sufficient cash inflows to compensate for tying up funds.

Which of the following are characteristics of the simple rate of return method for evaluating capital investment proposals?

- The simple rate of return fluctuates from year to year along with fluctuations in revenue and expense. - The simple rate of return ignores the time value of money.

Incremental Cost Approach

- better when only two decision are being looked at. gives a more simpler approach - only those costs and revenues that differ between the two alternatives are included in the analysis. - Only those cash flows that differ between the two alternatives are included in the analysis.

If a company's minimum required rate of return is used as the discount rate, a project with a:

- positive net present value will have a rate of return that exceeds the minimum required rate of return. - negative net present value is unacceptable.

Screening Decision

- relate to whether a proposed project is acceptable-whether it passes a preset hurdle.

The required rate of return:

- should be equal to or greater than the cost of capital. - is the minimum rate of return a project must yield to be acceptable. - The discount rate can also be referred to as:

Capital budgeting decisions focus on cash inflows and outflows rather than accounting income because:

- the present value of a cash flow depends on - - when it occurs. accounting net income is based on accruals.

Working capital is:

- treated as a cash outflow when required at the beginning of a project. - treated as a cash inflow when released at the end of a project.

Hurdle Rate Vs Discount Rate

-Hurdle rate is when the internal ROR method is used. -Discount rate is when the NPV method is used

How to evaulate a project using internal ROR and minimum required ROR

-in the internal ROR is compared the company's minimum required rate of return, which is usually the company's cost of capital. -IF THE INTERNAL RATE OF RETURN IS EQUAL OR GREATER THAT THE REQUIRED RATE OF RETURN, THEN THE PROJECT IS ACCEPTABLE.

Cash Inflows

-incremental revenues -reduction in costs -salvage value -release of working capital

Cash Outflows

-initial investment(including installation costs) -increased working capital needs -repairs and maintenance -incremental operating costs

Least cost decision

-method used when decision fo not involver any revenues(ie buying or leasing a jet) -can use either the total cost approach or the incremental cost approach with the least cost decisions.

Total Cost Approach

-the most flexible method for comparing competing projects. -All cash inflows and all cash outflows are included in the solution -NPV is computed for each alternative when comparing - All cash flows are included in calculating the net present value for each alternative.

Internal Rate of Return

-the rate of return of an investment project over its useful life. -computed by finding the discount rate that equates the present value of a project's cash outflows with the present value of its cash inflows. -internal ROR is the discount rate that results in a net present value of zero.

How do you find ROR if not the same inflow annually

-trial and error method

Cost of capital

-usually regarded as the minimum required rate of return. -is the average rate of return the company must pay to its long term creditors and its shareholders for the use of their funds. -if a project's ROR is less than the cost of capital, the compnay does not earn enough to compensate its creditors and shareholders. = any project with a ROR less than the cost of capital should be rejected.

Place the following steps for finding the internal rate of return (IRR) in the correct order.

1) Calculate the factor needed to determine the internal rate of return. 2) Find the line in the PV of an annuity table of the project years. 3) Trace the line across the table until the factor appear. 4) Trace up the column containing the factor to find the IRR.

Place the following steps used to calculate net present value in the correct order.

1) Determine the discount rate using the minimum required return. 2) Find the PV factors using the discount rate & timing of each cash flow. 3) Multiply all project cash flows by the present value factor. 4) Find the differences between the PV of cash inflows and cash outflows.

Capital Budgeting Decision

1. Cost Reduction Decisions 2. Expansion Decision 3. Equipment Selection Decision 4. Lease or Buy Decision 5. Equipment Replacement Decision

More

A dollar today is worth _____ than a dollar earned a year from now.

Working Capital

Current assets less current liabilities.

Salvage Value

Funds gained from the sale of a capital asset.

Initial Investment

Funds needed to purchase a capital asset or begin a capital investment project.

Factor of Internal ROR equation

Investment Req/ Annual net cash inflow -once you get the number go to the chart 13B-2 and find the factor that represents that number. The factor and end answer will be a %

Payback Period

Is the length of time that it takes for a project to recover its initial cost from the net cash inflows that it generates.

Project profitability index equation

Net present value of the project/investment required -the higher the number the more desirable the project

If the NPV is negative....

Not acceptable because its return is less than the required rate of return

Net Present Value

The differences between the present value of an investment project's cash inflows and the present value of its cash outflows.

Preference

The internal rate of return and the project profitability index are both tools used when making a ___________ decision concerning multiple acceptable investment projects.

Initial

The payback period is the length of time that it takes for a project to recover its _______ cost from the netcash inflows that it generates.

The internal rate of return is equal to or greater than the required rate of return:

The project is considered to be acceptable.

Acceptable project with a net present value of zero:

The project promises a return equal to the required rate of return.

Acceptable project with a positive net present value:

The project promises a return greater than the required rate of return.

Unacceptable project with a negative net present value:

The project promises a return less than the required rate of return.

The internal rate of return is less than the required rate of return:

The project should be rejected.

Long-Term

The term capital budgeting is used to describe how managers plan significant investments in projects that have ____ ____ implications.

Screening decisions and Preference decisions.

The two broad categories into which capital budgeting decisions fall

Net Present, Internal Rate of Return

The two capital budgeting approaches that use discounted cash flows are the ___ _______ value method and the _______ ____ __ ______ method.

Out of pocket costs

actual cash outlays for salries, advertising, and other operating expenses.

A postaudit is a valuable process because:

actual values can be used to determine if the project is performing as expected.

Payback Period equation

investment required/annual net cash flow

When using net present value to compare projects, the total cost approach:

is the most flexible method available to compare projects. includes all cash inflows and outflows under each alternative.

In a situation where the capital project will create no additional revenue for the company, the most desirable alternative is the one with the:

least total cost from the present value perspective.

The Time Value of Money

recognizes that a dollar today is worth more than a dollar a year from now if for no other reason than you could put the dollar in a bank today and have more than a dollar a year from now.

An investment requires committing funds today with:

the expectations of earning a return on those funds in the future.

The internal rate of return method indicates:

the rate of return promised by an investment project over its useful life.

The net present value of a project is:

used in determining whether or not a project is an acceptable capital investment. The difference between the present value of cash inflows and present value of cash outflows for a project.