Reading...
Play button
Play button
Use LEFT and RIGHT arrow keys to navigate between flashcards;
Use UP and DOWN arrow keys to flip the card;
H to show hint;
A reads text to speech;
54 Cards in this Set
- Front
- Back
|
Capital budgeting applications
|
Buying equipment
building facilities acquiring a business developing a product or product line expanding into new markets |
|
|
Why is planning cruicial
|
Changes in capital markets
Inflation, Interest rates Money supply |
|
|
Avoidable cost
|
may be eliminated by ceasing an activity or by improving efficiency
|
|
|
common cost
|
cost shared by all options and is not clearly allocable to any one of them.
|
|
|
Weighted average cost of capital
|
weighted average of the interest cost of debt (net of tax) and the costs (implicit or explicit) of the components of equity capital to be invested in long-term assets.
|
|
|
desired rate of return
|
minimum that the firm will accept. It may be the opportunity cost of funds, The WACC, or some other minimum.
|
|
|
Deferrable cost
|
may be shifted to the future with little or no effect on current operations.
|
|
|
Fixed cost
|
does not vary with the level of activity within the relevant range
|
|
|
Imputed cost
|
may not entail a specified dollar outlay formally recognized by the accounting system, but it is nevertheless relevant to establishing the economic reality analyzed in the decision making process.
|
|
|
incremental cost
|
the difference in cost resulting from selecting one option instead of another.
|
|
|
opportunity cost
|
benefit forone, such as contribution to income, buy not selecting the best alternative use of resources.
|
|
|
Relevant costs
|
vary with the action. Other costs are constant and therefore do not affect the decision.
|
|
|
Sunk COst
|
costs that cannot be avoided because an expenditure or irrevocable decision to incur the cost has been made.
|
|
|
ALl capital budgeting decisions need to be evaluated on an __________ Basis
|
AfterTax Basis
|
|
|
Stages in the capital budgeting process
|
Identification and definition
Search Information-acquisition Selection Financing Implementation and monitoring |
|
|
Steps in the ranking procedure
|
Determine the asset cost or net investment
Calculate estimated cash flows Relate the cash-flow benefits to their cost Rank the investments |
|
|
net investment
|
net outlay, or gross cash requirement minus cash recovered from the trade or sale of existing assets, with necessary adjustments for applicable tax consequences.
|
|
|
Book rate of return
|
GAAP net income from investment
________________________________________ Book value of investment |
|
|
Relevant cash flows (three categories)
|
Net initial investment
Annual net cash flows Project termination cash flows |
|
|
Net initial investment (3 types)
|
Purchase of new equipment
Initial working capital requirements After-tax proceeds from disposal of old equipment |
|
|
Annual net cash flows (2 types)
|
After-tax cash collections from operations
Tax savings from depreciation deductions |
|
|
depreciation tax shield.
|
Unlike the income from operations, the higher depreciation charges will generate a tax savings.
|
|
|
Incremental cash flow
|
the difference in cash received or disbursed resulting from selecting one option instead of another.
|
|
|
Sunk cost
|
one that is either already paid or irrevocably committed to incur.
|
|
|
Effects of inflation on capital budgeting
|
Inflation raises the hurdle rate.
In an inflationary environment, future dollars are worth less than today's dollars. thus, the firm will require a higher rate of return to compensate. |
|
|
Post investment audits
|
conducted to serve as a control mechanism and to deter managers from proposing unprofitable investments
|
|
|
widely used rates in capital budgeting
|
The firms weighted average cost of capital
The shareholders opportunity cost of capital |
|
|
IF the NPV of a project is_________ the project is desirable.
|
positive
|
|
|
If the IRR is _________ than the companies desired rate of return, the investment is desirable.
|
Higher
|
|
|
Managers concerned with shareholder wealth maximization should choose the project with the
|
Greatest NPV, not the largest IRR.
|
|
|
Payback period
|
number of years required to return the original investment; that is, the time necessary for a new asset to pay for itself.
|
|
|
Payback period Ratio
|
Initial net investment/Annual expected cash flow.
|
|
|
bailout payback method
|
incorporates salvage value of the asset into the calculation.
|
|
|
Payback reciprocal
|
sometimes used as an estimate of the internal rate of return.
|
|
|
breakeven time
|
the period required for the discounted cumulative cash inflows of a project to equal the discounted cumulative cash outflows.
|
|
|
capital rationing
|
exists when a firm sets a limit on the amount of funds to be invested during a given period.
|
|
|
Reasons for capital rationing
|
Lack of non monetary resources
A desire to control estimation bias. An unwillingness to issue new equity. |
|
|
Profitability index
|
a method for ranking projects to ensure that limited resources are placed with the investments that will return the highest NPV
|
|
|
Internal capital market
|
a way of referring to the provision of funds by one division to another division. A division operating in a mature industry that generates a lot of cash can provide funding to another division.
|
|
|
Linear programming
|
technique for optiming resource allocations so as to select the most profitable, or least costly way to use avialable resources
|
|
|
Informal risk analysis
|
NPV's are calculated at the firms desired rate of return, and the possible projects are individually reviewed.
|
|
|
Risk-adjusted discount rate
|
Adjusts the rate of return upward as the investment becomes riskier.
|
|
|
Certainty equivalent adjustments
|
forces the decision maker to specify at what point the firm is indifferent to the choice between a certain sum of money and the expected value of a risky sum.
|
|
|
Simulation analysis
|
Refinement of standard profitability theory. The computer is used to generate many examples of results based upon various assumptions.
|
|
|
Sensitivity analysis
|
Forecasts of many calculated NPV's under various assumptions are compared to see how sensitive npv is to changing conditions.
|
|
|
Monte Carlo technique
|
often used in simulation to generate the individual values for a random variable.
|
|
|
Real option
|
REduce risk of an investment project. The flexibility to affect the amounts and risk of an investment project's cash flows, to determine its duration, or to postpone its implementation.
|
|
|
The value of a real option
|
difference between the project's NPV without the option and its NPV with the option.
|
|
|
Replicating portfolio.
|
This method involves identifying securities trading in different public markets with cash flows that are the same as those of the real option.
|
|
|
Advantage to replicating portfolio
|
Does not require estimating a discount rate for a discounted cash flow analysis.
|
|
|
Disadvantage to replicating portfoliio
|
the need to estimate the effects on cash flows of multiple sources of risk.
|
|
|
Follow up investment
|
a second investment to expand capacity/make npv positive.
|
|
|
Flexibility option
|
to vary inputs
Example (switching fuels) |
|
|
Capacity option
|
To vary output, for example, to respond to economic conditions by raising or lowering output or by temporarily shutting down.
|
