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Definition
| 1. The length of time it takes for cumulative cash flows from a project to equal the original investment without taking account of the time value of money |
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Term
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Definition
| 2. For Capital Budgeting purposes, a determination of the annual sales level at which the project generates enough profit to return the original capital invested plus the cost of capital. |
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| 3. Net Present Value (NPV) |
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Definition
| 3. The current value of expected future net cash flows. |
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| 4. INternal rate of return (IRR) |
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Definition
| 4. The percentage rate ofreturn on invested funds that produces a net present value of zero |
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Definition
| 5. A project in which investment dollars are paid in oneperiod and income is received in subsequent periods |
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| 6. A project in which dollars are paid in one period and income is received in subsequent periods |
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| 7. A project in which money is received in one period and repaid in subsequent periods |
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Definition
| 8. The limitation of the amount of money a company can invest in a particular year |
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| 9. The limitation of capital available for investment for reasons determined by company management |
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Definition
| 10. The limitation of capital available for investment as a result of external constraints. |
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Term
| 1. Describe the process used in making capital budgeting decisions |
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Definition
1. The following process is used in making capital budgeting decisions:
a. measuring the risk-adjusted profitability of each alternative
b. ranking the alternatives according to their profitibility
c. choosing the one that provides the greates profit potential |
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Term
2. Describe the discount rate used by the following entities when making financial allocation decisions:
a. Investors
b. companies |
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Definition
2. the following rates are used as the discount rate when making financial decisions:
a. investors - use the required rate of return at the discount rate for any time-value-of-money calculations performed in making financial allocation decisions.
b. companies - use their weighted cost of capital as the discount rate in making allocation decisions |
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Term
| 3. Explain how to calculate the weighted average cost of capital. |
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Definition
3. To calculate the weighted average cost of capital (WACC)
(cost of equity x percentage equity) +
(cost of debt x percentage debt) |
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Term
| 4. Describe flotation costs, and explain why a company should consider them when making investment decisions. |
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Definition
| 4. Flotation costs are those associated with the issuance of new securities. They must be considered whe nmaking investment decisions. Although flotation costs do not increae the required rate of return on the investment, they do increase the amount of capital that must be raised to fund the project. |
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Term
5. Describe how the following capital investment evaluation strategies are used to analyze investment alternatives.
a. accounting rate of return
b. payback rule
c. breakeven analysis |
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Definition
5. The following capital investment evaluation strategies are used to analyze investment alternatives.
a. accounting rate of return - Calculated by dividing the annual net income by th avg return, or to a standard selected by mgmt, to determine whether to undertake a project
b. payback rule - payback is the length of time it takes for cumulative cash flows from a project payback period is compared with a standard that is set by the company, and the project is accepted if it is less than an equal to the standard.
c. breakeven analysis - determines the annual sales level at which the income from the project equals the costs of the project, as reported in the accounting records. Calculated as follows:
Breakeven sales= fixed costs (including depreciation) divided by profit percentage per sales dollar |
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| 6. ID the major flaw in using the accounting rate of return in assessing capital investment |
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Definition
| 6. The major flaw in using the accounting rate of return in assessing capital investment is that it incorrectly weights revenues and costs because it ignores the time value of money. Distant cash flows receive the same weight as early flows, yet they are not equal. |
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7. Describe the following costs used in capital investment breakdown analysis:
a. fixed costs
b. profit per sales dollar
c. variable costs |
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Definition
7. The following costs used in capital investment breakdown analysis:
a. fixed costs = costs that remain constant over a range of sales, such as depreciation, insurance, rent, and administrative salaries.
b. profit per sales dollar = equal to the sles price per unit less variable costs
c. variable costs = costs that are paid only when a sale occurs, such as the cost of material, costs of labor and sales commissions. |
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Term
| 8. Explain how using accounting brekeven differs from using economic breakeven when evaluating investment alternatives |
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Definition
8. A project that breaks even on an accounting basis can pay for its own fixed operating expenses but does not provide for the return of the original investment or any compensation for the use of the capital investment.
Ecomonic breakeven is used to determine the min sales level needed to cover all costs of an investment including both the cost of capital and the return of capital. the cost of equipment is included in the amount of the orig investment rather than being allocated over the investments useful life; therefore, depreciation is excluded from the fixed costs. This formula provides a more accurate determination of payback period than the accounting breakeven formula |
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Term
9. Describe how the following cash flow techniques are used to analyze investment alterntives:
a. Net present value (NPV)
b. Internal rate of return (IRR) |
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Definition
9. The following cash flow techniques are used to analyze investment alterntives:
a. Net present value (NPV) = The current value of expected future net cash flows. The NPV rule indictes that a company should accpet all independent projects whose NPV is greater than zero or, if two prjects are mutually exclusive, the one with the higher NPV.
(review formula)
b. Internal rate of return (IRR) - Percentage rate of return on invested funds that produces a net prsent value of zero. The IRR rule states that a company shoud accept those investment projects whose expected internal rate of return is greater than the cost of capital
(review formula) |
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Term
| 10. Distinguish between a lending project and a borrowing project |
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Definition
| 10. A lending project is one in which investment dollars are paid in one period and income is received in subsequent periods. A borrowing project is one in which money is received in one period and paid in subsequent periods |
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Term
| 11. Describe situations in which the IRR and NPV rules could lead to ambiguous decisions regarding investment decisions |
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Definition
11. The following situations coud lead to ambiguous decisions regarding investmetn decisions using NPV and IRR rules:
-Lending projects compared with borrowing projects: when a co borrows, it shoud do so at an IRR that is less than the rte that mus be pd for capital from alternative sources, generally choosing borrowing projects with a low IRR. If the NPV rule is used, the need to distinguish between borrowing and lending projects does not arise
-Multiple rates of return: These a present when the cash flows of the projects alternate from positive to negative cash flow more than once during the term of the project. Because IRR is the rate fo return at which the NPV of the investment is zero, each time the cash flow changes, a new IRR is created. This makes the IRR rule difficult to apply. The NPV rule should be used in this instance
Mutually Exclusive Projects-Differences in the scale or cash flow patern of the projects can led to ambiguous decisions. The co should estimate its cost of capital and then choose the project with the higher NPV since the NPV of a project represents the change in the co's net worth |
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Term
| 12. Differentiate the two forms of capital rationing used to limit a company's capitl expenditures |
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Definition
12. The following are two forms of capital rationing used to limit a company's capitl expenditures:
a. soft rationing-A way for mgmt to control spending and to focus on the projects that are most likely to create the greatest increase in shareholder wealth. Soft rationing is accomplished by setting specific limits on the amts of capital available for investment or by increasing the cost of capital to be used as the discount rte for NPV and IRR calculations
Hard Rationing: The limitation of capital available for investment as a result of external constraints |
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| 13. List reasons why a company may have diffficulty raising capital for investments |
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Definition
13. A company may have diffficulty raising capital for investments for the following reasons:
1. The company is under financial distress
2. The credit environment is difficult
3. The company does not yet have a track record |
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| 14. Describe how an insurance contract follows the cash flow pattern of a borrowing project |
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Definition
| 14. An insurance contract follows the cash flow pattern of a borrowing project because the insurer receives the gross premium (less production and other expenses) and subsequently pays claims from these funds. |
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| 15. Explain how the discount rate affects an insurance policy's value |
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Definition
| 15. As the discount rate increases, an insurance policy adds more value to the insurer. The value increase for an insurance policy is derived from the spread between the discount rate and the inflation rate. The greater the spread, the higher the value added. |
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| 16. ID a possible use of capital budgeting by an insurer. |
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Definition
| 16. An insurer might use capital budgeting to ID the effects that writing, or reducing, lines of business will have on the company's value. |
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Term
| 17. ID sources of insurance company income used in an insurer's capital budgeting decisions in determining underwriting profit margins in insurance rates. |
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Definition
| 17. An insurer uses Underwriting and net investment income in making capital budgeting decisions to determine underwriting profit margins in insurance rates. |
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Term
| 18. Describe how an insuer's investment income and underwriting profits are affected by the competitive market. |
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Definition
| 18. Competition affects an insurer's investment income because it forces the insurer to pay market prices for investment assets. It affects an insurer's underwriting profits because the insrer needs to charge the market price for its policies to stay in business. |
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