Finance Chapter 9

Concerning Discounted Paybacks: C) What conceptual advantage does the discounted payback method have over the regular payback method? Can the discounted payback ever be longer than the regular payback? Explain.

Discounted payback is an improvement on regular payback because it takes into account the time value of money. For conventional cash flows and strictly positive discount rates, the discounted payback will always be greater than the regular payback period.

Payback Period Rule Advantages

Includes time value of money Easy to understand Does not accept negative estimated NPV investments Biased toward liquidity

Payback Period Rule Disadvantages

May reject positive NPV investments Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against long-term projects, such as research and development, and new projects

Concerning Discounted Payback: B) What are the problems associated with using the discounted payback period to evaluate cash flows?

The primary disadvantage to using the discounted payback method is that it ignores all cash flows that occur after the cutoff date, thus biasing this criterion towards short-term projects. As a result, the method may reject projects that in fact have positive NPVs, or it may accept projects with large future cash outlays resulting in negative NPVs. In addition, the selection of a cutoff point is again an arbitrary exercise.

Discounted Cash Flow (DCF) Valuation

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

Required Rate of Return and NPV Relationship

As the required rate of return increases, the NPV of the project decreases

Why Capital Budgeting Decisions are so Important

Impact of decision is long-term Usually involves large expenditure amounts Reflect commitment to major strategic decisions

Concerning NPV: A) Describe how NPV is calculated, and describe the information this measure provides about a sequence of cash flows. What is the NPV criterion decision rule?

NPV is simply the present value of a project's cash flows. NPV specifically measures, after considering the time value of money, the net increase or decrease in firm wealth due to the project. The decision rule is to accept projects that have a positive NPV, and reject projects with a negative NPV.

Concerning NPV: B) Why is NPV considered a superior method of evaluating the cash flows from a project? Suppose the NPV for a project's cash flows is computed to be $2,500. What does this number represent with respect to the firm's shareholders?

NPV is superior to the other methods of analysis presented in the text because it has no serious flaws. The method unambiguously ranks mutually exclusive projects, and can differentiate between projects of different scale and time horizon. A project with NPV = $2,500 implies that the total shareholder wealth of the firm will increase by $2,500 if the project is accepted.

Mutually Exclusive Projects

Projects where the acceptance of one means the others cannot be undertaken (that is, usually alternative ways to do a similar thing)

Concerning Payback: B) What are the problems associated with using the payback period to evaluate cash flows?

The worst problem associated with payback period is that it ignores the time value of money. In addition, the selection of a hurdle point for payback period is an arbitrary exercise that lacks any steadfast rule or method. The payback period is biased towards short-term projects; it fully ignores any cash flows that occur after the cutoff point.

Internal Rate of Return Disadvantages

may result in multiple answers or not deal with nonconventional cash flows May lead to incorrect decisions in comparisons of mutually exclusive investments

Mutually Exclusive Investment Decisions

A situation in which taking one investment prevents the taking of another

Internal Rate of Return Advantages

Closely related to NPV, often leading to identical decisions Easy to understand and communicate

Concerning Payback: C) What are the advantages of using the payback period to evaluate cash flows? Are there any circumstances under which using payback might be appropriate? Explain.

Despite its shortcomings, payback is often used because (1) the analysis is straightforward and simple and (2) accounting numbers and estimates are readily available. Since payback is biased towards liquidity, it may be a useful and appropriate analysis method for short-term projects where cash management is most important.

Concerning IRR: C) Despite its shortcomings in some situations, why do most financial managers use IRR along with NPV when evaluating projects? Can you think of a situation in which IRR might be a more appropriate measure to use than NPV? Explain.

IRR is frequently used because it is easier for many financial managers and analysts to rate performance in relative terms, such as "12%", than in absolute terms, such as "$46,000." IRR may be a preferred method to NPV in situations where an appropriate discount rate is unknown are uncertain; in this situation, IRR would provide more information about the project than would NPV.

Concerning IRR: B) What is the relationship between IRR and NPV? Are there any situations in which you might prefer one method over the other? Explain.

IRR is the interest rate that causes NPV for a series of cash flows to be zero. NPV is preferred in all situations to IRR; IRR can lead to ambiguous results if there are non-conventional cash flows, and it also ambiguously ranks some mutually exclusive projects.

Payback Weaknesses

Ignores the time value of money (and thus does not consider risk very well). Ignores cash flows that may occur after the payback period There is no objective decision rule ("short" seems good, but no clear definition of "how short" is "good enough" - user has to make an arbitrary rule)

Capital Budgeting

Is the process of planning and evaluating expenditures on assets whose cash flows (costs and/or benefits) will take place over more than one year

Concerning Payback: A) Describe how the payback period is calculated and describe the information this measure provides about a sequence of cash flows. What is the payback criterion decision rule?

Payback period is simply the accounting break-even point of a series of cash flows. To actually compute the payback period, it is assumed that any cash flow occurring during a given period is realized continuously throughout the period, and not at a single point in time. The payback is then the point in time for the series of cash flows when the initial cash outlays are fully recovered. Given some predetermined cutoff for the payback period, the decision rule is to accept projects that payback before this cutoff, and reject projects that take longer to payback.

Independent Projects

Projects that do not require or prevent any other projects from being undertaken.

Expansion Projects

Projects to purchase capital assets and add them to existing assets to increase existing operations.

Replacement Projects

Projects to purchase capital assets to take the place of existing assets to maintain or improve existing operations

Concerning IRR: A) Describe how the IRR is calculated, and describe the information this measure provides about a sequence of cash flows. What is the IRR criterion decision rule?

The IRR is the discount rate that causes the NPV of a series of cash flows to be exactly zero. IRR can thus be interpreted as a financial break-even rate of return; at the IRR, the net value of the project is zero. The IRR decision rule is to accept projects with IRRs greater than the discount rate, and to reject projects with IRRs less than the discount rate.

Payback Period

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

Net Present Value (NPV)

The difference between investment's market value and its cost

Internal Rate of Return (IRR)

The discount rate that makes the NPV of an investment zero The compound rate of return that the firm expects to earn on a project, over the life of the project The discount rate that forces the PV of the annual expected CFs of a project to exactly equal the project's initial cost IRR for a capital project is like YTM for a bond

Concerning Discounted Payback: A) Describe how the discounted payback period is calculated, and describe the information this measure provides about a sequence of cash flows. What is the discounted payback criterion decision rule?

The discounted payback is calculated the same as is regular payback, with the exception that each cash flow in the series is first converted to its present value. Thus discounted payback provides a measure of financial/economic break-even because of this discounting, just as regular payback provides a measure of accounting break-even because it does not discount the cash flows. Given some predetermined cutoff for the discounted payback period, the decision rule is to accept projects whose discounted cash flows payback before this cutoff period, and to reject all other projects.

Discounted Payback Period

The length of time required for an investment's discounted cash flows to equal its initial cost