Capital Budgeting

• The main objective is to maximize the value of the company.
• When the discount rate increases; the present value decreases. When the discount rate decreases; the present value increases.
• To make a capital decision, a manager must estimate the timing of cash flows, quantity of cash flows, and risk of the investment.
• A depreciation tax shield is a reduction in income taxes.
• The stage of the capital budgeting process that has the most risk is forecasting cash flow.
• Cash outflows include: (1) Purchase price plus directly attributable costs; (2) working capital requirement; and (3) market value of currently idle assets to be used in the project.
• The accounting rate of return focuses on income as opposed to cash flow.
• The ARR does not recognize TVM.
• The formula for ARR is Average Income over Net Investment.
• The time required for a firm to recover its original investment is the payback period.
• If the cash flows of a project are received evenly over the life of the project, the formula for the calculation of the payback period is Original investment over annual cash flow.
• The payback method does not consider TVM.
• When the risk of obsolescence is high, managers will want a shorter payback period.
• The payback reciprocal can be used to approximate a project's IRR.
• The drawback of the payback period is that it ignores a project's total profitability.
• The bailout payback method calculates the payback period using the sum of the net cash flows and the salvage value.
• The bailout period would always be shorter than the payback period.
• The NPV provides an absolute peso measure.
• If the resulting net present value is negative, then the return on investment is less than the discount rate.
• Under the NPV method, the required rate of return is also called as cutoff rate, cost of capital, hurdle rate, or discount rate.
• Depreciation is incorporated explicitly in the discounted cf analysis of an investment proposal because it reduces the cash outlay for income taxes.
• The best model for choosing the best of several competing projects is net present value.
• Given that an entity has unlimited capital funds, the best decision rule is to invest in projects in which the npv is greater than 0.
• The interest rate that sets the present value of a project's cash inflow equal to the present value of the project's cost is called IRR.
• The internal rate of return is the rate of interest for which the npv is equal to zero.
• The IRR is favorable when it exceeds the hurdle rate.
• Assume that an investment project's assumed cash flows are not changed, but the assumed wacc is reduced. This would increase the npv and the irr will not change.
• Independent projects - unrelated to one another
• Mutually exclusive projects - competing alternatives where investing in one removes the possibility in investing in another