Chapter 9

payback period

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

net present value

the difference between an investment's market value and its cost (positive=creates value, negative=destroys value)

Internal rate of return (IRR)

the discount rate that makes the NPV of an investment zero, internal rate in the fact that it depends only on the cash flows of a particular investment, not on rates offered elsewhere

discounted payback period

the length of time required for an investments discounted cash flows to equal its initial cost, if project ever pays back on a discounted basis then it must have a positive NPV due to the fact that the NPV is 0 when the sum of discounted cash flows equals the initial investment

multiple rates of return

the possibility that more than one discount rate will make the NPV of an investment zero

Profitability Index

the present value of an investment's future cash flows divided by its initial cost, also called the benefit-cost ratio

discounted cash flow (DCF) valuation

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

a firm that only accepts projects for which the IRR is equal to the firm's required return will, on average, neither create nor destroy wealth for its shareholders

true

an advantage of the payback rule is that it is easy to understand

true

for projects with conventional cash flows and positive discount rates, the payback period will be shorter than the discounted payback period

true

payback rule pros

used by large companies when making relatively minor decisions, b/c its biased towards short term its biased towards liquidity, it also adjusts for extra riskiness by ignoring the late cash flows all together

profitability index pros

1. closely related to NPV, generally leading to identical decisions 2. easy to understand and communicate 3. may be useful when available investment funds are limited

IRR pros

1. closely related to NPV, often leading to identical decisions 2. easy to understand and communicate

discounted payback pros

1. includes TVM 2. easy to understand 3. doesn't accept negative estimated NPV investments 4. biased towards liquidity

discounted payback cons

1. isn't any simpler to use than NPV, not especially simple to calculate so not used a lot 2. cutoff still has to be arbitrarily set 3. cash flows beyond cutoff are ignored 4. biased against long term projects 5. may reject positive NPV investments

IRR problems

1. nonconventional cash flows, changing signs multiple times 2. mutually exclusive investments makes IRR's misleading

which of the following questions are addressed in capital budgeting process?

1. what products or services will we offer or sell? 2. in what markets will we compete? 3. what new products will we introduce?

payback rule cons

1. when calculating we simply add up future cash flows, there's no discounting so it ignores TVM 2. fails to consider any risk differences, calculated same way for both risky and safe projects 3. biggest problem is that cutoff period is arbitrarily chosen, no good way to calculate correct period time 4. bias towards short term products, makes them appear more profitable

which consider the time value of money in their computation?

IRR and profitability index

net present value profile

a graphical representation of the relationship between an investment's NPVs and various discount rates

mutually exclusive investment decisions

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

which factors can cause a project to have multiple IRRS?

an initial cash investment followed by a positive cash flows for 3 years and a negative cash flows in the final year

the crossover point

equates the net present values of 2 separate projects

the internal rate of return (IRR) decision rule states that projects should be accepted whenever the IRR..

exceeds the required return

the profitability index is computed using accounting income and accounting book values

false, uses PV of future cash flows/initial cost

when to accept/reject using IRR

if IRR>required return you accept, otherwise you reject

profitability index cons

may lead to incorrect decisions in comparisons of mutually exclusive investments