FINC 300 - CHAPTER 9 Capital Budgeting: Net Present Value and Other Investment Criteria
____________ budgeting is the decision-making process for accepting and rejecting projects.
Capital
Non-conventional Cash flows
Cash flows change sign more than once - Means you have more than one IRR
Reinvestment Approach
Compound all cash flows (negative and positive) except the initial investment to the end of the project's life
Net Present Value (NPV)
Difference between investment's market value and its costs
Discounting Approach
Discount all negative cash flows to present at required return and add to initial cost
Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period?
Discounted payback period
What are the THREE approaches to modifying cash flows?
Discounting Approach Reinvestment Approach Combination Approach
The profitability index is calculated by dividing the PV of the _________ cash flows by the initial investment.
Future
IRR Rule
Investment is acceptable if IRR EXCEEDS the required return
NPV Rule
Investment is accepted if NPV is positive and rejected if negative
If a project has multiple internal rates of return, which of the following methods should be used?
NPV & MIRR
Advantages of AAR
Needed information is usually available. Is easy to compute.
Which of the following are advantage(s) of AAR?
Needed information is usually available. Is easy to compute.
Combination Approach
Negative cash flows are discounted back to the present, and positive cash flows are compounded to the end of the project
__________ is a measure of how much value is created or added today by undertaking an investment.
Net Present Value
Examples of capital budgeting include:
New machinery Replacement machinery New plants New products Research & development projects
NPV and IRR rules always lead to identical decisions except under WHICH two conditions?
Non-conventional and mutually exclusive cash flows
This capital budgeting method allows lower management to make smaller, everyday financial decisions effectively.
Payback method
Probability Index
Present value of the future cash flows DIVIDED by the initial investment
Which of the following is an example of an opportunity cost?
Rental income likely to be lost by using a vacant building for an upcoming project
Internal Rate of Return (IRR)
Required return that results in a ZERO NPV when it is used as the discounted rate
Using the payback period rule will bias toward accepting which type of investment?
Short-term investment
In which of the following scenarios would IRR always recommend the wrong decision?
Starting cash flow: 1000 Ending cash flow: -2000
Mutually exclusive cash flows
Taking one investments prevents taking another
What are the advantages of the payback period method for management?
The payback period method is ideal for short projects. It allows lower level managers to make small decisions effectively. The payback period method is easy to use.
True or False: Payback period does not include time value of money. Discounted payback includes time value of money.
True
True or false: Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified number of years.
True
True or false: The crossover rate is the rate at which the NPVs of two projects are equal.
True By definition, the crossover rate occurs when the NPVs of two mutually exclusive projects are equal.
True or false: Some projects, such as mines, have cash outflows followed by cash inflows, which are then followed by cash outflows, giving the project multiple rates of return.
True Whenever subsequent cash flows are both negative and positive, multiple internal rates of return will occur.
Multiple rates of return
With nonconventional cash flows, there is a possibility that more than one discount rate will make the NPV of an investment zero.
Modified Internal Rate of Return (MIRR)
a capital budgeting method that converts a project's cash flows using a more consistent reinvestment rate prior to applying the IRR decision rule
When is the average accounting return acceptable?
a project is acceptable if its average accounting return exceeds a target average accounting return.
The internal rate of return is a function of ____.
a project's cash flows
The PI rule for an independent project is to ______ the project if the PI is greater than 1.
accept
A project should be __________ if its NPV is greater than zero.
accepted
NPV ____ cash flows properly
discounts
The three attributes of NPV are that it:
discounts the cash flows properly. uses cash flows. uses all the cash flows of a project.
The AAR _________ (does/doesn't) incorporate time value of money.
does
An independent project _______ (does/doesn't) rely on the acceptance or rejection of another project.
doesn't
A situation in which taking one investment prevents the taking of another is called a mutually _______ investment decision.
exclusive
The basic NPV investment rule is:
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. reject a project if its NPV is less than zero.
The IRR can lead to the wrong decision when cash ________ (inflows/outflows) occur before cash _________ (inflows/outflows).
inflows, outflows
The payback period method allows lower management to make _________ (smaller/larger), everyday financial decisions effectively.
larger
By ignoring time value, the payback period rule may incorrectly accept projects with a _______ (positive/negative) NPV.
negative
By ignoring time value, the payback period rule may incorrectly accept projects with a _______ NPV.
negative
The ____________ method differs from NPV because it evaluates a project by determining the time needed to recoup the initial investment.
payback
For a project with conventional cash flows, the NPV is ______ if the required return is less than the IRR, and it is ______ if the required return is greater than the IRR.
positive, negative
In capital budgeting, the net ______ determines the value of a project to the company.
present value
The IRR rule can lead to bad decisions when _____ or _____.
projects are mutually exclusive cash flows are not conventional
According to the basic IRR rule, we should _____.
reject a project if the IRR is less than the required return
Internal rate of return (IRR) must be compared to the ________ in order to determine the acceptability of a project.
required return
The payback period method allows lower management to make ___________, everyday financial decisions effectively.
smaller
Capital Budgeting
the process of planning and managing a firm's long-term investments
Crossover rate
the rate at which the NPVs of two projects are equal
The IRR is the discount rate that makes the NPV of a project equal to ______.
zero
The spreadsheet function for calculating net present value is ____.
=NPV()