Finance Chapter 7

Pitfalls of Payback

-•Ignores the project's cost of capital and time value of money. •Ignores cash flows after the payback period.

When does IRR disagree with NPV

•Delayed Investments •Nonexistent IRR •Multiple IRRs

Payback Rule

-the amount of time it takes to recover or pay back the initial investment.

The Net Present Value (NPV)

-the difference between the present value of its benefits and the present value of its costs. -When making an investment decision, take the alternative with the highestNPV.

capital budgeting

-the set of valuation techniques for real asset investment decisions. - to accept or reject: •NPV •IRR •Payback period

Mutually exclusive project

•- if the cash flows of one can be adversely impacted by the acceptance of the other. •A set of projects where only one can be accepted: if one project is taken on, the other must be rejected. -accept project with highest NPV

Criteria for IRR

•IRR will always agree with NPV on investment decisions if the following 2 criteria are met: 1)The cash flows of the investment start out negative, and then switch to positive and stay positive throughout the life of the investment (normal projects) 2)The investment decision for one investment does not impact the investment decision of another investment (independent projects)

Decision Rule for IRR

•If IRR is > than a prespecified benchmark rate of return, then accept •If IRR is < than the benchmark, then reject -The benchmark rate of return is the discount rate

•How do we make investment decisions using payback period?

•If the payback period is SHORTER than a benchmark period of time, then accept the investment. - Otherwise, reject the investment.

IRR

•the interest rate that sets the net present value of the cash flows equal to zero -IRR measures the average return of the investment and the sensitivity of the NPV to any estimation error in the cost of capital.

NPV: accept or reject a project

-Accept if NPV > 0, i.e. accept positive NPV projects. -Reject if NPV < 0, i.e. reject negative NPV projects.

9) The maximum number of incremental IRRs that could exist for project B over project A is: A) 1 B) 2 C) 0 D) 3

- answer: 2

4) Which of the following statements is FALSE? A) The incremental IRR need not exist. B) If a change in the timing of the cash flows does not affect the NPV, then the change in timing will not impact the IRR. C) Although the incremental IRR rule can provide a reliable method for choosing among projects, it can be difficult to apply correctly. D) When projects are mutually exclusive, it is not enough to determine which projects have positive NPVs.

- answer: If a change in the timing of the cash flows does not affect the NPV, then the change in timing will not impact the IRR.

3) Which of the following statements is FALSE? A) In general, the difference between the cost of capital and the IRR is the maximum amount of estimation error in the cost of capital estimate that can exist without altering the original decision. B) The IRR can provide information on how sensitive your analysis is to errors in the estimate of your cost of capital. C) If you are unsure of your cost of capital estimate, it is important to determine how sensitive your analysis is to errors in this estimate. D) If the cost of capital estimate is more than the IRR, the NPV will be positive.

- answer: If the cost of capital estimate is more than the IRR, the NPV will be positive.

4) Which of the following statements is FALSE? A) In general, the IRR rule works for a stand-alone project if all of the project's positive cash flows precede its negative cash flows. B) There is no easy fix for the IRR rule when there are multiple IRRs. C) The payback rule is primarily used because of its simplicity. D) No investment rule that ignores the set of alternative investment alternatives can be optimal.

- answer: In general, the IRR rule works for a stand-alone project if all of the project's positive cash flows precede its negative cash flows.

6) You are trying to decide between three mutually exclusive investment opportunities. The most appropriate tool for identifying the correct decision is: A) NPV. B) profitability index. C) IRR. D) incremental IRR.

- answer: NPV

1) Which of the following statements is FALSE? A) About 75% of firms surveyed used the NPV rule for making investment decisions. B) If you are unsure of your cost of capital estimate, it is important to determine how sensitive your analysis is to errors in this estimate. C) To decide whether to invest using the NPV rule, we need to know the cost of capital. D) NPV is positive only for discount rates greater than the internal rate of return.

- answer: NPV is positive only for discount rates greater than the internal rate of return.

7) Which of the following statements is FALSE? A) The IRR investment rule states you should turn down any investment opportunity where the IRR is less than the opportunity cost of capital. B) The IRR investment rule states that you should take any investment opportunity where the IRR exceeds the opportunity cost of capital. C) Since the IRR rule is based upon the rate at which the NPV equals zero, like the NPV decision rule, the IRR decision rule will always identify the correct investment decisions. D) There are situations in which multiple IRRs exist.

- answer: Since the IRR rule is based upon the rate at which the NPV equals zero, like the NPV decision rule, the IRR decision rule will always identify the correct investment decisions.

1) Which of the following statements is FALSE? A) Problems can arise using the IRR method when the mutually exclusive investments have different cash flow patterns. B) The IRR is affected by the scale of the investment opportunity. C) Multiple incremental IRRs might exist. D) The incremental IRR rule assumes that the riskiness of the two projects is the same.

- answer: The IRR is affected by the scale of the investment opportunity.

2) Which of the following statements is FALSE? A) It is possible that an IRR does not exist for an investment opportunity. B) If the payback period is less than a pre-specified length of time you accept the project. C) The internal rate of return (IRR) investment rule is based upon the notion that if the return on other alternatives is greater than the return on the investment opportunity you should undertake the investment opportunity. D) It is possible that there is no discount rate that will set the NPV equal to zero.

- answer: The internal rate of return (IRR) investment rule is based upon the notion that if the return on other alternatives is greater than the return on the investment opportunity you should undertake the investment opportunity.

•Reinvestment Rate Assumption:

-NPV assumes cash flows are reinvested at company's cost of capital (i.e.: the investors' required rate of return). -IRR assumes cash flows are reinvested at IRR. -The NPV reinvestment rate assumption is more realistic.

2) Which of the following statements is FALSE? A) The incremental IRR investment rule applies the IRR rule to the difference between the cash flows of the two mutually exclusive alternatives. B) When a manager must choose among mutually exclusive investments, the NPV rule provides a straightforward answer. C) The likelihood of multiple IRRs is greater with the regular IRR rule than with the incremental IRR rule. D) Problems can arise using the IRR method when the mutually exclusive investments have differences in scale.

- answer: The likelihood of multiple IRRs is greater with the regular IRR rule than with the incremental IRR rule.

5) Which of the following statements is FALSE? A) The payback rule is useful in cases where the cost of making an incorrect decision might not be large enough to justify the time required for calculating the NPV. B) The payback rule is reliable because it considers the time value of money and depends on the cost of capital. C) For most investment opportunities expenses occur initially and cash is received later. D) Fifty percent of firms surveyed reported using the payback rule for making decisions.

- answer: The payback rule is reliable because it considers the time value of money and depends on the cost of capital.

3) Which of the following statements is FALSE? A) When using the incremental IRR rule, you must keep track of which project is the incremental project and ensure that the incremental cash flows are initially positive and then become negative. B) Picking one project over another simply because it has a larger IRR can lead to mistakes. C) Problems arise using the IRR method when the mutually exclusive investments have differences in scale. D) When the risks of two projects are different, only the NPV rule will give a reliable answer.

- answer: When using the incremental IRR rule, you must keep track of which project is the incremental project and ensure that the incremental cash flows are initially positive and then become negative.

5) Consider two mutually exclusive projects A & B. If you subtract the cash flows of opportunity B from the cash flows of opportunity A, then you should: A) take opportunity A if the regular IRR exceeds the cost of capital. B) take opportunity A if the incremental IRR exceeds the cost of capital. C) take opportunity B if the regular IRR exceeds the cost of capital. D) take opportunity B if the incremental IRR exceeds the cost of capital.

- answer: take opportunity A if the incremental IRR exceeds the cost of capital.

21) When using the internal rate of return (IRR) investment rule, we compare: A) the average return on the investment opportunity to returns on all other investment opportunities in the market. B) the average return on the investment opportunity to returns on other alternatives in the market with equivalent risk and maturity. C) the NPV of the investment opportunity to the average return on the investment opportunity. D) the average return on the investment opportunity to the risk-free rate of return.

- answer: the average return on the investment opportunity to returns on other alternatives in the market with equivalent risk and maturity.

17) The NPV profile graphs: A) the project's NPV over a range of discount rates. B) the project's IRR over a range of discount rates. C) the project's cash flows over a range of NPVs. D) the project's IRR over a range of NPVs.

- answer: the project's NPV over a range of discount rates.

12) When choosing between projects, an alternative to comparing their IRRs is: A) to compute the incremental IRR, which tells us the discount rate at which it becomes profitable to switch from one project to the other. B) to compute the incremental payback period, which tells us the number of years during which it becomes profitable to switch from one project to the other. C) to compute the incremental NPV, which tells us the discount rate at which it becomes profitable to switch from one project to the other. D) There is no alternative selection criterion to comparing IRRs.

- answer: to compute the incremental IRR, which tells us the discount rate at which it becomes profitable to switch from one project to the other.

22) The internal rate of return rule can result in the wrong decision if the projects being compared have: A) differences in scale. B) differences in timing. C) differences in NPV. D) A and B are correct.

- answer: two answers: - differences in scale. - differences in timing.

18) The NPV profile A) shows the payback period - the point at which NPV is positive. B) shows the internal rate of return - the point at which NPV is zero. C) shows the NPV over a range of discount rates. D) B and C are correct.

- answer: two answers: - shows the internal rate of return - the point at which NPV is zero. - shows the NPV over a range of discount rates.

Independent Project

- if the cash flows of one are unaffectedby the acceptance of the other. -accept all positive independent projects

Delayed Investment

- you get advance of 1 m, but lose 500,000 each year for 3 years, DR = 10% -You calculate IRR --> 23 > 10% but you must check NPV -You calculate NPV and its negative < 0 REJECT --> when IRR and NPV don't agree go with NPV