Chapter 9: NPV and other Investment Criteria

Saxon Company is considering a project that will generate net income of $50000 in Year 1, $75000 in Year 2, and $90000 in Year 3. The cost of the project is $700000, and this cost will be depreciated to zero in three years of the investment. What is their average accounting return?

20.48% average net income is (50000+75000+90000)/3=71670. The average accounting return is 71670/350000=20.48%

Capital Corp is considering a project whose internal rate of return 14%. If Capital's required return is 14%, the project's NPV is:

0

Which of the following projects is acceptable if the average accounting return is required to be at least 20%?

1) Restaurant: Average income= $450,000, Average book value= $2,180,000 2) Book store: Average income= $140,000, Average book value= $600,000

How does the timing and the size of cash flows affect the payback method? Assume the project does pay back within the projects lifetime.

An increase in the size of the first cash inflow will decrease the payback period, all else held constant.

Project alpha's NPV profile crosses the vertical axis at $230,000. Project Beta's NPV profile crosses the vertical axis at $150,000. If projects alpha and beta have conventional cash flows, are mutually exclusive and the NPV profiles cross at 15% (Where the NPV's are positive), which of the projects has a higher internal rate of return?

Beta: The 2 projects have a crossover point above the horizontal axis, and Alpha crosses the vertical axis above beta. Because the cash flows are conventional, their NPV profiles cross only once, so alpha must have a steeper NPV profile, but beta must have a higher IRR.

What is the NPV of a project with an initial investment of $95, a cash flow in one year of $107, and a discount rate of 6 percent?

$5.94 NPV= -95 + (107 / 1.06)= 5.94

Which of the following are mutually exclusive investments?

- 2 different choices for the assembly lines that will make the same product - a restaurant or gas station on the same piece of land

According to Graham and Harvey's 1999 survey of 392 CFOs (published in 2001), which of the following two capital budgeting methods are widely used by firms in the US and Canada?

- net present value - internal rate of return

The discounted payback period has which of these weaknesses?

-Arbitrary cutoff date -Loss of simplicity as compared to the payback method -exclusion of some cash flows.

Which of the following are advantages of AAR?

-Is easy to computer -Needed information is usually available

If a project has multiple internal rates of return, which of the following methods should be used?

-NPV -MIRR

When cash flows are conventional, NPV is ____.

-Positive for discount rates below the IRR, -equal to zero when the discount rate equals the IRR, -negative for discount rates above the IRR.

What is the IRR for a project with an initial investment of $250 and subsequent cash inflows of $100 per year for 3 years?

9.70%

The spreadsheet function for calculating net present value is:

=NPV()

The internal rate of return is a function of ____.

A project's cash flow

The PI rule for an independent project is to ______ the project if the PI is greater than 1.

Accept

The most important alternative to NPV is the _______ method.

Internal rate of return

IRR continues to be very popular in practice, partly because:

It gives a rate of return rather than a dollar value

Payback period (PBP)

Last year with negative cumulative cash flow + (Absolute value of the last year's negative cumulative cash flow/the cash flow of the following year of negative cumulative cash flow)

This Capital budgeting method allows lower management to make smaller, everyday financial decisions effectively.

Payback method

The IRR rule can lead to bad decisions when _____ or ______.

Projects are mutually exclusive, cash flows are not conventional.

NPV ____ cash flows properly

discounts

The profitability index is calculated by dividing the present value of ______ cash flows by the initial cost (or initial investment) of the project.

future

A(n) __________ project does not rely on the acceptance or rejection of another project.

independent

The point at which the NPV profile crosses the horizontal axis is the:

internal rate of return

According to the average accounting return rule, a project is acceptable if:

its aar exceeds a target aar

By ignoring time value, the payback period rule may accept projects with a ________ NPV.

negative

One of the flaws of the payback period method is that cash flows after the cutoff date are ___

not considered in the analysis

the amount of time needed for the cash flows from an investment to pay for its initial cost

payback period

In capital budgeting, the net ______ determines the value of a project to the company.

present value

Internal rate of return (IRR) must be compared to the _______ in order to determine the acceptability of a project.

required return

In which of the following scenarios would IRR always recommend the wrong decision?

start CF= 1000 End CF= -2000

The payback period rule _________ a project if it has a payback period that is less than or equal to a particular cutoff date.

suggests accepting

Net Present Value (NPV)

the difference between an investment's market value and its cost

internal rate of return (IRR)

the discount rate that results in an NPV of zero for a project

Capital budgeting

the process of planning and managing a firm's long-term investments

The basic NPV investment rule is:

-reject a project if its NPV is less than zero -if the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference -accept a project if the NPV is greater than zero

Arrange the steps involved in the discounted payback period in order starting with the first step.

1. Discount the cash flows using the discount rate 2. Add the discounted cash flows 3. Accept if the discounted payback period is less than some pre-specified number of years

The present value of all cash flows after the initial investment is divided by the _____to calculate the profitability index.

initial investment

Payback Period

investment required/annual net cash inflow

Payback period tells the time it takes to break even in an _________ sense. Discounted payback period tells the time it takes to break even in an ________ or financial sense.

Accounting; Economic

discounted cash flow (DCF) valuation

the process of valuing an investment by discounting its future cash flows