Chapter 9

Internal rate of return and net present value

According to Graham and Harey's 1999 survey of 392 CFOs, which two capital budeting methods are most used by firms in the US?

A target average accounting return

According to the average accounting return rule, a project is acceptable if its average accounting return exceeds:

True

T or F: Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified number of years.

True

T or F: IRR approach may lead to incorrect decisions in comparison of two mutually exclusive projects.

False

T or F: Investing more money in a project will always lead to greater profits.

True

T or F: The crossover rate is the rate at which the NPVs of two projects are equal.

Accept

The PI rule for an independent project is to ___ the project if the PI is greater than 1.

Payback period

The amount of time needed for the cash flows from an investment to pay for its initial cost is the:

- Accept a project if the NPV is greater than zero - Reject a project if its NPV is less than zero - If the NPV is equal to zero, acceptance or rejection of the project is a matter of indefference.

The basic NPV investment rule is:

short-term

Using the payback period rule will bias toward accepting which type of investment?

- Is easy to compute - Needed information is usually available.

What are advantages of AAR?

Negative

By ignoring time value, the payback period rule may accept projects with a _____ NPV

Zero

Capital Corp is considering a project whose internal rate of return is 14%. If Capital's required return is 14%, the projects NPV is:

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

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.

It gives a rate of return rather than a dollar value.

IRR continues to be very popular in practice, partly because:

Not considered in the analysis

One of the flaws of the payback period method is that cash flows after the cutoff date are:

Capital Budgeting

The decision-making process for accepting and rejecting projects.

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

The discounted payback period has what weaknesses?

A project's cash flows

The internal rate of return is a function of:

Independent

An ____ project does not rely on the acceptance or rejection of another project.

MIRR and NPV

If a project has multiple internal rates of return, what methods should be used?

present value (NPV)

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

Whenever cash inflows exceed cash outflows, the NPV profile is upward sloping; the IRR will give the wrong decision EX. Starting cash flow: $1000 Ending cash flow: $-2000

In what senoarios would IRR always recommend the wrong decision?

Discounts

NPV _____ cash flow properly.

Future

The profability index is calculated by dividing the PV of the ___ cash flows by the initial investment

=NPV(rate,value1,[value2],...)

The spreadsheet function for calculating NPV is:

Payback method

This capial budgeting method allows lower management to make smaller, everyday financial decisions effectively.

1. Discount the cash flows using the discount rate. 2. Add the discounted cash flows. 3. Accept if the discounted payback period is less than some pre-specified number of years.

What are the steps involved in the discounted payback period in order?

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

What are two examples of being a mutually exculive investment?

- Positive for discount rates below the IRR - Equal to zero when the discount rate equals the IRR - Negative for discount rates above the IRR

When cash flows are conventional, NPV is:

BETA (NPV cross only once. Since Alpha must have a steeper NPV profile, Beta must have a higher IRR)

Project Alpha's NPV profile crosses the vertical axis at $230,000. Project Beta's NPV profile crosses the vertical axis at $150,000. If project Alpha and Beta have conventional cash flows, are mutually exclusive and te NPR profiles cross at 15%, which of the projects has a highter internal rate of return.

9.70%

What is the IRR for a project with an inital investment of $250 and subsequesnt cash inflows of $100 per year for 3 years?

5.94 NPV= -95+(107/1.06) = 5.94

What is the NPV of a project with an inital investment of $95, a cash flow in one year of $107, and discount rate of 6%?

Negative

When cash flows are conventional, NPV is ___ if the discount rate is about the IRR.

Reject a project if the IRR is less than the required return.

According to the basic IRR rule, we should:

Accounting; economic

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.

20.48% Average net income is (50,000+75,000+90,000)/3 = 71,667. Average book value of investment is ($700,000+0)/2 = $350,000. Average accounting return is 71,667/ 350,000 = 20.48%

Saxon Company is considering a project that will generate net income of $50,000 in Year 1, $75,000 in Year 2, and $90,000 in Year 3. The cost of the project is $700,000, and this cost will be depreciated to zero in the three years of the investment. What is their average accounting return?

True

T or F: 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.

- Cash flows are not conventional - Projects are mutually exclusive

The IRR rule can lead to bad decisions when ___ or ___.

Internal rate of return

The most important alternative to NPV is the ____ method.

Suggest accepting

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

Internal rate of return (IRR)

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

Initial investment

The present value of all cash flows (after the initial investment) is divided by the ___ to calculate the profability index.