Finance Unit 3

What the important criteria for capital budgeting rules?

1. Adjusts for TVM 2. Adjusts for risk 3. Adjusts for opportunity costs 4. Provides info about value creation of project

advantages of NPV rule

1. accounts for TVM 2. adjusts for risk through required return and next best return of similar risk 3. gives direct measure of potential impact on stock price

advantages of discounted payback rule

1. adjusts for TVM 2. adjusts for risk through required return and cutoff limit

disadvantages of IRR

1. cannot be used for nonconventional projects 2. cannot compare mutually exclusive projects because it ignores scale 3. only gives return per dollar, not actual value of a project

disadvantages of NPV rule

1. complicated procedure 2. cannot determine NPV without required return

disadvantages of PI rule

1. does not always work with mutually exclusive projects - ignores scale

disadvantages of discounted payback rule

1. does not value a project

advantages of payback rule

1. easy to understand 2. favors liquid projects 3. adjusts for risk by not including later cash flows

advantages of IRR rule

1. frames decision in terms of rates not dollars 2. easy to understand 3. accounts for TVM 4. adjusts for risk by comparing IRR to required return 5. can get a rate with only estimated cash flows

disadvantages of payback rule

1. ignores TVM 2. only works for conventional projects 3. biased against long term projects 4. does not give value of project

advantages of PI

1. ranks projects with limited funds 2. does not accept negative NPV projects

True or false? A conventional project with an extremely large initial outflow can result in multiple IRRs.

False

True or false? A disadvantage of the IRR rule is that it complicated and difficult to interpret intuitively.

False

True or false? A disadvantage of the profitability index is that it only works for conventional projects, where the initial cost shows up in the denominator

False

True or false? According to Descartes' rule, conventional projects could have more than one IRR.

False

True or false? Both the IRR and the profitability index account for scale.

False

True or false? Conflicts between the NPV and IRR rules will occur when the projects' NPV profiles have a crossover point.

False

True or false? Even if projects have multiple IRRs, there is only one crossover point.

False

True or false? For a conventional project with a given preset limit, if it pays back on a discounted basis, it need not pay back on a nominal one.

False

True or false? For conventional projects, the discounted payback period will be less than that of nominal payback.

False

True or false? For conventional projects, the profitability index is the present value of a project's future net incomes divided by the initial cost.

False

True or false? For projects with conventional cash flows, the nominal payback period is longer than that of discounted payback

False

True or false? For projects with multiple cash flows you must use trial-and-error to solve for a crossover point.

False

True or false? IRR provides an indication of how much value a project is expected to create or destroy

False

True or false? If a conventional project has a negative NPV, it may still be accepted under the IRR rule.

False

True or false? Like NPV, the profitability index ignores the scale of a project

False

True or false? NPV profiles are smoothly declining monotonic functions.

False

True or false? Nominal payback ignores the time value of money and does not adjust for risk.

False

True or false? The IRR rule ignores the time value of money.

False

True or false? The IRR rule states that a company should accept projects that have an IRR greater than zero.

False

True or false? The NPV and IRR rule will conflict when the company faces mutually exclusive projects.

False

True or false? The NPV is the most commonly used capital budgeting tool used by treasury departments.

False

True or false? The crossover point is the NPV that sets the IRRs of two mutually exclusive projects to be equal.

False

True or false? The crossover point is the rate or return that sets two mutually exclusive projects' NPVs equal to zero.

False

True or false? The crossover point is where two mutually exclusive projects have the same IRRs.

False

True or false? The payback rule is biased against liquidity.

False

True or false? The profitability index is the capital budgeting tool of choice when dealing with mutually exclusive projects.

False

True or false? There can be multiple PIs if the cash flows are unconventional

False

True or false? When allocating scarce capital, firms should invest in the lowest PI,s first then invest in successively higher PIs

False

True or false? When faced with mutually exclusive projects, the profitability index is the "go to" rule.

False

True or false? When the discount rate is smaller than the crossover point, the NPV and IRR rules agree.

False

True or false? You must be careful when faced with mutually exclusive projects because the NPV and IRR rules will conflict.

False

internal rate of return rule

If a project's IRR is greater than the rate of return on the next best investment of similar risk, accept the project. Otherwise, reject the project.

discounted payback rule

If a project's discounted payback period is less than the pre-specified time limit, then the firm should accept the project.

crossover point

the discount rate at which the NPVs of two projects are equal NPV and IRR methods will yield different recommendations for which project to pursue

Internal Rate of Return (IRR)

the discount rate that makes a project's net present value zero the discount rate that sets PV of project inflows equal to PV of outflows

when to accept a project based on IRR rule

when IRR is higher than required return

When do NPV rule and IRR rule agree?

when required return is higher than crossover point

True or false? A firm that only accepts projects for which the IRR equals its required return will not create value for the owners.

True

True or false? A project's projected cash flows reflect the net of the inflows and outflows at each point in time.

True

True or false? All capital budgeting rules begin with estimating a project's expected cash flows.

True

True or false? Because economic agents view risk as an economic bad, capital budgeting rules should take risk into account.

True

True or false? Descartes' rule states that there could be as many IRRs as there are cash flow sign changes.

True

True or false? For a conventional project, NPV is the difference between the project's cost and the present value of its expected future cash flows.

True

True or false? If the PI is one then the discount rate is the IRR.

True

True or false? Mutually exclusive projects do not have to have a crossover point.

True

True or false? One advantage of the payback rule is that it is easy to understand.

True

True or false? The IRR and PI share a common disadvantage; they both ignore the scale of the project.

True

True or false? The NPV rule means that a company should accept projects that cost less than they are worth.

True

True or false? The preset limit for discounted payback is arbitrary.

True

True or false? The profitability index adjusts for the time value of money

True

True or false? Treasury uses PI to rank positive NPV projects on a value creation per dollar basis when funds are limited

True

Which capital budgeting rules are biased towards liquidity?

payback and discounted payback

payback period

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

net present value profile

A graphical plot of a project's NPV (Y) versus the discount rate (X).

non-conventional project

A project cash with outflows not characterized by a single initial expenditure.

conventional project

A project with an initial cash outflow followed by future cash inflows.

primary capital budgeting tool used in Finance 300

NPV rule

discounted payback period

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

mutually exclusive

The case when pursuing one project physically precludes another project.

Net Present Value (NPV)

The present value of the cash inflows less the present value of the cash outflows associated with a project.

Descartes' rule

The property of polynomials that there could be as many internal rates of return as there are sign changes for a project's cash flows.

profitability index

The ratio of the present value of a project's cash inflows to outflows ratios greater than one create value, while those less than one destroy it. useful capital budgeting tool when firms have limited capital.

multiple internal rate of returns

When a project has more than one discount rate yields a zero net present value. May occur when there are multiple cash flow sign changes, but not for conventional projects.

when to accept a project based on discounted payback rule

accept if discounted payback period is less than predetermined time limit

when to accept a project based on payback rule

accept if payback period is less than predetermined time limit

when to accept a project based on PI rule

choose projects with highest PI first, avoid project with PI less than one

when to accept a project based on NPV rule

equation results in positive NPV

payback rule

if a project's payback period is less than the pre-specified limit, then the firm should accept the project

net present value rule

if the present value of a project's cash inflows is greater than the present value of its cash outflows, then accept the project