6 Capital Budgeting Free Online FlashCards

What is capital budgeting?

Capital budgeting evaluates long-term investments that commit resources now in expectation of future benefits.

What does net present value measure?

NPV is the present value of expected project cash inflows minus the present value of cash outflows: $\text{NPV}=-I_0+\sum_{t=1}^{n}\frac{CF_t}{(1+r)^t}$.

What should a project’s discount rate reflect?

Use a discount rate that reflects the opportunity cost of capital and the project’s risk. A project with materially different risk may need a different rate.

What is the internal rate of return (IRR)?

The internal rate of return is the discount rate that makes a project’s NPV equal to zero.

How is payback calculated with equal annual inflows?

With equal annual inflows, payback period equals the initial investment divided by the annual cash inflow: $\text{Payback}=I_0/CF$.

Which cash flows belong in a project evaluation?

Include cash flows that change because the firm undertakes the project, including effects on existing sales, costs, and operations.

When should an independent project be accepted under the NPV rule?

Accept an independent project when its NPV is positive; it is expected to add value after covering the required return.

How does NPV rank mutually exclusive projects?

Generally choose the alternative with the highest positive NPV, provided the projects are compared on a consistent basis.

When does the IRR rule accept an independent project?

For conventional cash flows, accept an independent project if its IRR exceeds the required return.

Why can IRR be misleading?

IRR can misrank mutually exclusive projects of different scale or timing, and cash flows that change direction more than once can produce multiple or no meaningful IRRs.

What are key limitations of ordinary payback?

Ordinary payback ignores the time value of money and cash flows after the cutoff, so it does not measure total value created.

How should sunk costs and opportunity costs be treated?

Exclude sunk costs because they cannot be recovered through the current decision. Include opportunity costs when project resources could be used elsewhere.