LS5
decision rule for project where 1st cash flows are negative (2):
1. accept if IRR < discount rate 2. reject if IRR > discount rate
project with negative initial CF followed by positive CF (2):
1. accept if NPV is greater than 0 2. reject if IRR is less than market rate of financing
2 mutually exclusive projects can be evaluated by (2)
1. comparing NPVs 2. comparing incremental IRR to discount rate
weaknesses of the payback method (3)
1. gives equal weight to all CF before cutoff date 2. CF received after payback period are ignored 3. cutoff date is arbitrary
discount rate of project reflects (2):
1. opportunity cost of investor 2. risk of project
3 attributes of NPV
1. uses CF 2. uses all CF of the project 3. discounts CF properly
what does value additivity mean for a firm (2)
1. value of a firm = combined value of firm's projects, divisions, and entities owned by the firm 2. NPV values of individual projects can be added together
for a project with a positive initial CF followed by negative CF... accept if:
IRR < R
must know discount rate to COMPUTE _________ and to APPLY __________
NPV; IRR
in capital budgeting, the net ________ is the value of a project to the company
PV
the IRR is the discount rate that makes the NPV of a project equal to ______
ZERO
payback rule _______ (accepts/rejects) project if it has a payback period that is less than or equal to a particular cutoff date
accepts
major problem with discounted-payback-period method
arbitrary cutoff date
discounted payback period
capital budgeting decision method that finds the present value of each CF before calculating payback period
type of rationing when firm can't raise more money from capital markets
hard rationing
payback period can lead to incorrect decisions because it...
ignores cash flows after the cutoff date
how does timing and size of CF affect payback method? assume project does pay back within project's lifetime
increase in size of cash inflow will decrease the payback period, all else held constant
NPV of project's CF is divided by __________ to calculate profitability index
initial investment
project with initial cash outflow followed by a cash inflow has an NPV that is ________ (negatively/positively) related to the discount rate
negatively
discount rate
opportunity cost
discount rate also referred to as
opportunity cost
the ________ method differs from the NPV because it evaluates a project by deteriming the time needed to recoup the initial investmentq
payback
For "normal" CF (outflows before inflows), the NPV is ______ if the discount rate is less than the IRR and it is _______ if the discount rate is greater than the IRR
positive; negative
internal rate of return is a function of _________
projects CFs
capital ___________ = firm doesn't have enough capital to fund all its positive NPV projects
rationing
opportunity cost of capital determined by the _________ of the project
risk
most important alternative to NPV
internal rate of return method
steps involved in discount payback period (3)
1. discount CF using discount rate 2. add discounted CF 3. accept if the discounted payback period is less than some pre-specified number of years
2 challenges with IRR approach when comparing 2 projects:
1. scale 2. differing CF patterns over time
