chapter 8 finance: NPV

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Why do we say that the payback period is, in a sense, an accounting break-even measure?

Because time value if ignored, you can think of the payback period as the length of time it takes to break even in an accounting sense, but not in an economic sense.

Average Accounting Return Rule

Based on the average accounting return rule, a project is acceptable if its average accounting return exceeds a target average accounting return.

payback period

The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.

Advantages of IRR

correlates with NPV easy to undertsand and communicate

Disadvantages of payback period rule

ignores time value of money requires cutoff point ignores cash flows after cutoff date biased against long term projects

Disadvantages of PI

may lead to incorrect decisions in comparisons of mutually exclusive decisions

Disadvantages of IRR

may result in multiple answers with nonconventional cash flows may lead to incorrect decisions in mutually exclusive investment decisions

Discounted Cash Flow Valuation

(a) Valuation calculating the present value of a future cash flow to determine its value today. (b) The process of valuing an investment by discounting its future cash flows.

Mutually exclusive investment decisions

A situation where taking one investment prevents the taking of another.

Advantages of PI

Closely related to NPV, generally leading to identical decisions. Easy to understand and communicate may be useful when available investments are limited

Multiple rates of return

The possibility that more than one discount rate will make the net present value of an investment zero.

Net Present value

The difference between an investment's market value and its cost. An investment should be accepted if the net present value is positive and rejected if it is negative.

Npv=0

investment is economically a break-even proposition when the NPV is zero because value is neither created nor destroyed.

Advantages of AAR

easy to calculate needed info will usually be available

Advantages of Payback period Rule

easy to understand adjusts for uncertainties of later cash flows biased towards liquidity

Irr Rule

Based on the IRR rule, an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.

Profitability Index

The present value of an investment's future cash flows divided by its initial cost. Also benefit-cost ratio The profitability index is defined as the PV of the cash inflows divided by the PV of the cash outflows

Disadvantages of AAR

not a true rate of return uses an cutoff rate based on accounting net income and book values, not cash flows and market values

How would you state the profitability index rule?

If the profitability index or ratio is greater than 1, the project is profitable and may receive the green signal to proceed. Conversely, if the profitability ratio or index is below, the optimum course of action may be to reject or abandon the project.

IRR

The discount rate that makes the net present value of an investment zero. The IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate.

What does the profitability index measure?

is the ratio of payoff to investment of a proposed project.

Average Accounting Return

An investment's average net income divided by its average book value.

Payback Rule

Based on the payback rule, an investment is acceptable if its calculated payback period is less than some pre-specified number of years.

If we say an investment has an NPV of $1,000, what exactly do we mean?

It's market value is 1000 above costs. It will increase stock value by 1000.

What is the NPV rule?

rule stating that an investment should be accepted if its net present value is greater than zero and rejected otherwise. According to the theory of net present value (NPV), participating in a positive NPV project will increase firm or shareholder wealth.


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