Chapter 9: Net Present Value and Other Investment Criteria

Advantages of Profitability Index

-Closely related to NPV, generally leading to identical decisions -Easy to understand and communicate -May be useful when available investment funds are limited

The discounted payback period has which of these weaknesses?

-Exclusion of some cash flows -Loss of simplicity as compared to the payback method -Arbitrary cutoff date

IRR is popular in practice because it fills a need NPV does not

in analyzing investments there is preference for rates of return rather than dollar values

The point at which the NPV profile crosses the horizontal axis is the

internal rate of return

the chief drawback of average accounting return

it is a ration of two accounting numbers and is not comparable to the returns offered

Based on payback rule, an investment is acceptable if its calculated payback period is

less than some prespecified number of years

an investment should be rejected if

net present value is negative

an investment should be accepted if

net present values is positive

In capital budgeting, the net ______ determines the value of a project to the company.

present value

NPV calculation

present value - cost of getting those cash flows

According to the basic IRR rule, we should

reject a project if the IRR is less than the required return

Average Accounting Return is defined as

some measure of average accounting profit / some measure of average accounting value

based on the discounted payback rule and investment is acceptable if its discounted payback is less than

some prespecified number of years

The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cutoff date.

suggests accepting

The point at which the NPV profile crosses the vertical axis is the:

sum of the cash flows of the project

Based on the average accounting return rule, a project is acceptable if its average accounting return exceeds a _____________average accounting return.

target or goal

Based on the IRR rule, an investment is acceptable if

the IRR exceeds the required return, should be rejected otherwise

pay back 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 an investment's market value and its cost, meausre of how much value is created or added today by undertaking an investment, assessing the profitability of a proposed investment, preferred approach in principle not always in practice

Internal Rate of Return (IRR)

the discount rate that makes the NPV of an investment zero, try yo find a single rate of return that summarizes the merits of a project, internal so is depends only on the cash flows of a particular investment, not on rates offered elsewhere

the crossover rat be definition is

the discount rate that makes the NPVs of two projects equal

discounted payback period

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

multiple rates of reutrn

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

discounted cash flow (DCF) valuation

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

capital budgeting

trying to determine whether a proposed investment or project will be worth more, once it is in place, than its cost, search for investments with positive net present values

the IRR on an investment is required return that results in a zero NPV when

used as the dicount rate

probelems with the IRR

when cash flows are not conventional or when we are trying to compare two or more investments to see which is best

IRR sometimes called

discount cash flow

payback period disadvantages

-Ignores the time value of money -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

disadvantages of internal rate of return

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

disadvantages of average accounting return

-Not a true rate of return; time value of money is ignored -Uses an arbitrary benchmark cutoff rate -Based on accounting net income and book values, not cash flows and market values

advantages of internal rate or return

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

problems with MIRR

-different ways of calculating -no clear reason to say one of the three is better than the other -not clear how to interpret

advantages of average accounting return

-easy to calculate -needed information will usually be available

payback period advantages

-easy to understand -adjusts for uncertainty of later cash flows -biased toward liquidity

The basic NPV investment rule is:

-if the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference -reject a project if its NPV is less than zero. -accept a project if the NPV is greater than zero.

problems with average accounting return

-ignores time value (no discounting) -lack of objective cutoff period -doesn't look at the right things ( instead of cash flow and market value it uses net income and book value)

advantages of discounted payback period rule

-includes time value of money -easy to understand -does not accept negative estimated NPV investments -biased toward liquidity

IRR and NPV rules lead to identical decisions as long as two very important conditions are met

-projects cash flows must be conventional, meaning the first cash flow is negative and all the rest is positive -the project must be independent, meaning the decision to accept or reject this project does not affect the decision to accept or reject any other

compared to NPV rule payback periods short comings

-time value of money completely ignored -fails to consider risk differences -coming up with right cutoff period

The three attributes of NPV are that it

-uses cash flows. -discounts the cash flows properly. -uses all the cash flows of a project.

disadvantages of discounted payback period rule

1. May reject positive NPV investments 2. Requires an arbitrary cutoff point 3. Ignores cash flows beyond the cutoff date 4. Biased against long-term projects, such as research and development, and new projects

Arrange the steps involved in the discounted payback period in order starting with the first step.

1. discount the cash flows using the discount rate 2. add the discount cash flows 3. Accept if the discounted payback period is less than some prespecified number of years

Which of the following are mutually exclusive investments?

A restaurant or a gas station on the same piece of land. Two different choices for the assembly lines that will make the same product.

How does the timing and the size of cash flows affect the payback method? Assume the project does pay back within the project's lifetime.

An increase in the size of the first cash inflow will decrease the payback period, all else held constant.

Disadvantages of Profitability Index

May lead to incorrect decisions in comparisons of mutually exclusive investments

In which of the following scenarios would IRR always recommend the wrong decision?

Starting cash flow: 1000 Ending cash flow: -2000

Based on the _________________ payback rule, an investment is acceptable if its ____________________payback is less than some prespecified number of years.

discounted

Calculating MIRR requires

discounting, compounding or both leading to: -if we have the relevant discount rate why not calculate the NPV and be done with it -because it depends on an externally supplied discount rate the answer you get is not truly internal rate of return depends on only the projects cash flows

An independent project___________ rely on the acceptance or rejection of another project.

doesn't

Profitability Index (PI)

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

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

net present value profile

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

The internal rate of return is a function of

a project's cash flows

mutually exclusive investment decisions

a situation in which taking one investment prevents the taking of another, if two investments are mutually exclusive

based on the average accounting return rule a project is acceptable if its average accounting return exceeds

a target average accounting return

Based on the average ____________return rule, a project is acceptable if its average ___________return exceeds a target average __________return.

accounting

Payback period tells the time it takes to break even in an ____ sense. Discounted payback period tells the time it takes to break even in an ______ or financial sense.

accounting; economic

Average Accounting Return (AAR)

an investment's average net income divided by its average book value

Average Accounting Return is specifically defined as

average net income / average book value

if a project has a positive NPV then the present value of the future cash flows must be

bigger than the initial investment, profitability index will be bigger than 1 for a positive NPV and less than 1 for a negative NPV

payback period can be thought of as the length of time to

break even

the only way to find the IRR in general is

by trial and error, either hand or caluclator

The IRR rule can lead to bad decisions when _____ or _____

cash flows are not conventional projects are mutually exclusive