3. Why is the concept of present value relevant to capital budgeting, but not so
ID: 2501014 • Letter: 3
Question
3. Why is the concept of present value relevant to capital budgeting, but not so relevant to other types of budgeting?
You have to be familiar with the concepts of present value in order to successfully handle the NPV and IRR techniques.
4. Describe the Payback Period in your own words. Under what circumstances would Payback be an effective method to use in evaluating competing investment alternatives?
Number of months or years estimated to be taken for a full capital recovery from an investment.
5. Describe the Accounting Rate of Return in your own words. What are its weaknesses as an investment evaluation tool?
6. Describe the calculation of NPV in your own words. What does the word "Net" in Net Present Value refer to?
7. Define the Internal Rate of Return.
8. Johnson Company plans to spend $3,993 on a 5 year project that will return $1,000 cash per year. Calculate the IRR; is it 8%?
Explanation / Answer
Answer:3 The concept of present value is relevant to capital budgeting because for the purpose of calculation of NPV, discounted payback period and IRR.You will have to become familiar with the concepts of present value in order to successfully handle the NPV and IRR techniques
Answer:4 The Payback Method determines how long it will take to recover the original investment, based on the savings generated each year by the investment. It focuses on cash flows, so depreciation charges must be added back to net income.
Answer:5 This method calculates the ratio of the annual net income divided by the average investment in the project. In the text example on page 1268, a company is planning to purchase new equipment that will generate net income of $60,000 per year for six years, and will have an initial cost of $240,000. With a $240,000 cost and six-year life, the depreciation expense each year will be $40,000. This means that the net income will be $60,000-$40,000=$20,000 per year.
The Annual Rate of Return Method has some inherent weaknesses:
It focuses upon net income, rather than cash flow;
It ignores the time value of money, in that income to be earned in the early years is weighted exactly equally to income to be earned later in the investment life;
This numerator of this ratio is usually net income, rather than cash flow; better investment-analysis techniques focus on the cash to be received from an investment;
It is inflexible with respect to evaluating fluctuating income amounts during the project.
Answer:6 NPV=PV of cash inflows-PV of cash outflow.
Because it is consistent and measures time value of money.
Answer:7 The Internal Rate of Return is that rate of return which makes the NPV exactly equal to zero.
Answer:8 Yes
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