Cash Flow
Actual cash inflows received and actual cash outflows made for out-of-pocket. costs such as salaries, advertising, repairs and similar costs. Net cash flows are cash inflows less cash outflows. Net cash flows are not the same as operating income:
Cash flo
payback
The amount of time required for an investment to generate cash flows sufficient to recover its initial cost. Payback period = original investment/Cash inflows per period
internal rate of return (IRR)
solves for the discount rate which makes the net present value of an investment project's future net cash flows equal to net initial cash outflows, i.e., the internal rate of return sets the net present value = 0. IRR > Cost of Capital, ACCEPT project
Net Present Value (NPV)
computes the difference between the present value of an investment project's future net cash flows and net initial cash outflows using a known discount rate. The net present value method always uses cash flows, not operating income. Present Value Inflows-
mutually exclusive
A statistical term used to describe a situation where the occurrence of one event is not influenced or caused by another event. In addition, it is impossible for mutually exclusive events to occur at the same time.
reinvestment assumption
an assumption made concerning the rate of return that can be earned on the cash flows generated by capital budgeting projects;assumes the rate of reinvestment to be the cost of capital
Modified Internal Rate of Return (MIRR)
While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed at the firm's fin
capital rationing
At times management may place an artificial constraint on the amount of funds that can be invested in a given period. A firm may adopt a posture of capital rationing because it is fearful of too much growth or hesitant to use external sources of financing
net present value profile
a graphic presentation of the potential net present values of a project at different discount rates. It is very helpful in comparing the characteristics of two or more investments.
modified accelerated cost recovery system (MACRS)
Depreciation method that specifies the useful life and depreciable percentages for designated categories of assets. Used only for income tax purposes.
asset depreciation range (ADR)
this represents the expected physical life of an asset. Generally the midpoint of the ADR is utilized to determine what class an asset falls into for depreciation purposes.
replacement decision
The financial manager often needs to determine whether a new machine with advanced
technology can do the job better than the machine being used at present.
incremental depreciation
the depreciation on a new asset minus the depreciation on an old asset. Incremental depreciation is multiplied times the tax rate to determine its tax shield benefit
elective expensing
writing off an asset in the year of purchase for tax purposes rather than depreciating it over the life of the asset. The maximum annual deduction is $250,000. This procedure is primarily beneficial to small business because its availability is phased out
capital budgeting
The process of planning significant investments in projects that have long lives and affect more than one future period, such as the purchase of new equipment
time value of money
Money's potential to grow in value over time. The relationship between time, money, a rate of return, and earnings growth.
cost of capital
The rate of return a company must earn in order to meet the demands of its lenders and expectations of its equity holders. Also the discount rate used to determine the equity value of an asset. It is usually around 10-15%.
What are the important administrative considerations in the capital budgeting process?
Important administrative considerations relate to: the search for and discovery of investment opportunities, the collection of data, the evaluation of projects, and the reevaluation of prior decisions.
Why does capital budgeting rely on analysis of cash flows rather than on net income?
Cash flow rather than net income is used in capital budgeting analysis because the primary concern is with the amount of actual dollars generated. For example, depreciation is subtracted out in arriving at net income, but this non-cash deduction should be
What are the weaknesses of the payback method?
The weaknesses of the payback method are:
a. There is no consideration of inflows after payback is reached.
b. The concept fails to consider the time value of money.
What is normally used as the discount rate in the net present value method?
The rate of return a company must earn in order to meet the demands of its lenders and expectations of its equity holders. Also the discount rate used to determine the equity value of an asset. It is usually around 10-15%.
What does the term mutually exclusive investments mean?
The selection of one investment precludes the selection of other alternative investments because the investments compete with one another. For example if a company is going to build one new plant and is considering 5 cities, one city will win and the othe
How does the modified internal rate of return include concepts from both the traditional internal rate of return and the net present value methods?
The modified internal rate of return calls for the determination of the interest rate that equates future inflows to the investment as does the traditional internal rate or return. However, it incorporates the reinvestment rate assumption of the net prese
If a corporation has projects that will earn more than the cost of capital, should it ration capital?
From a purely economic viewpoint, a firm should not ration capital. The firm should be able to find additional funds and increase its overall profitability and wealth through accepting investments to the point where marginal return equals marginal cost
What is the net present value profile? What three points should be determined to graph the profile?
The net present value profile allows for the graphic portrayal of the net present value of a project at different discount rates. Net present values are shown along the vertical axis and discount rates are shown along the horizontal axis.
The points that
How does an asset's ADR (asset depreciation range) relate to its MACRS category?
The ADR represents the asset depreciation range or the expected physical life of the asset. Generally, the midpoint of the range or life is utilized. The longer the ADR midpoint, the longer the MACRS category in which the asset is placed. However, most as
Compound interest
assumes that the current investment (present value) and interest rate are known and the future value is to be calculated. The future value is calculated as follows: FV = PV (1+i)n where i is the interest rate and n is the number of periods.
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Present value
Present value assumes that the future value(s) and discount rate are known and the present value is to be calculated. The present value is calculated as follows: PV = FV / (1+i)n where i is the interest rate and n is the number of periods.
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