fin ch 9

if a project ever pays back on a discounted basis, it's NPV will be

+

disadvantages of the IRR

-can lead to multiple rates of return with nonconventional CFs (want NPV to be positive between the multiple rates) -ignores scale -may lead to incorrect decisions when comparing mutually exclusive investments (because it ignores scale) -doesn't tell manager how much value a project will add, it just gives the return per dollar

advantages of discounted payback

-includes TVM -doesn't accept projects with a negative NPV -biased towards liquidity -simple -doesn't accept non conventional projects

Mutually exclusive projects have NPV profiles that do not cross.

False

Nominal payback ignores the time value of money and does not adjust for risk.

False

The NPV rule does not adjust for the riskiness of a project's cash flows.

False

The profitability index is useful when corporations try to decide between mutually exclusive projects.

False

You must be careful when faced with mutually exclusive projects because the NPV and IRR rules will conflict.

False

An advantage of discounted payback is that it does not accept negative NPV investments when a project's cash flows are unconventional.

False- CONVENTIONAL

A conventional project has a smoothly increasing NPV profile that crosses the x-axis only once.

False- DECREASING

If your PI is one, the rate you're using is the

IRR

which rules provide an indication about the increase in value?

NPV

crossover point

the discount rate at which the NPVS of two projects are equal if a crossover point exists, there is a range of discount rates where the NPV and IRR rules conflict conflict arises when the required return is higher than the crossover point

A conventional project has a smoothly declining NPV profile that crosses the x-axis only once.

True

For conventional projects, there is an inverse relationship between the present value of the inflows and the discount rate.

True

Mutually exclusive projects do not have to have a crossover point.

True

PI Procedure: 1. Estimate a project's expected future cash flows. 2. Using the required return, divide the present value of all the cash inflows by the present value of all the cash outflows. 3. Reject if the profitability index is less than one.

True

PI adjusts for TVM

True

The NPV rule: If the NPV is negative, reject the project because it will decrease the stock's price.

True

The discounted payback rule severely adjusts for the risk of a project's cash flows because it does so two ways.

True

When looking at two NPV profiles that cross, if the required return is to the left of the crossover point, then the NPV and IRR rules will disagree.

True

mutually exclusive

taking one investment prevents the taking of another physical constraint *always choose one with highest NPV

NPV definition

the difference between an investment market value and its cost how much value is created today by undertaking an investment

Which of the following capital budgeting rules are biased towards liquidity? A. payback. B. net present value C. profitability index D. discounted payback E. internal rate of return F. None of these rules is

A,D

when r is infinity, NPV is

CF today

minimum growth rate is where

NPV = 0

NPV index and PI

NPV Index = PI - 1

with conventional cash flows, when r increases

NPV decreases

conflicts between NPV/IRR

NPV directly measures increase in value to firm do always use NPV in conflict (though IRR is #1 in real world) IRR is unreliable with nonconventional CFs and mutually exclusive projects

inflows/outflows in NPV

NPV is PV inflows - PV outflows PV outflows is what you're paying and PV inflows is what it's worth don't pay more than what something is worth, that's value destroying

which rules account for TVM?

NPV, IRR, PI, Discounted Payback

conventional project

a project with an initial cash outflow followed by future cash inflows

Descartes' rule

property of polynomials says that there could be as many IRRs as there are sign changes for a project's CFs

IRR ignores

scale

fundamental business decisions

capital budgeting is the most important question of finance the most fundamental decisions a business can make concerns its product lines

finding the crossover rate

compute the irr on the difference of the cash flows

finding the crossover rate

set NPVs equal collect terms on one side (find differences between project CFs) use CF function to find IRR (but note that that is your crossover rate NOT an IRR)

good decision criteria

does the decision rule adjust for the TVM? does the decision rule adjust for risk? does the decision rule provide information on whether we are creating value for the firm?

biggest advantage of PI

may be helpful when available investment funds are limited (use to try and allocate scarce resources) also, doesn't accept negative NPV projects

in the real world, where do firms put most of their energy?

mostly step 1- estimating expected CFs and determining the right OC

can a conventional project have multiple IRRs?

no

do financial constraints indicate mutual exclusivity?

no FC is a CF constraint ME is a physical constraint

if it doesn't pay back in normal payback, will it payback with discounted?

no, discounted is always later

non-conventional project

outflows are not characterized by a single initial expenditure

questions to find how much value is created from undertaking an investment?

estimate expected future CFs estimate the required return for projects of this risk level find the PV of all the cash inflows/outflows and add them up

calculating payback

estimate expected future CFs subtract future CFs from initial cost until initial investment has been recovered

estimating NPV

estimate future CFs use DCF to find PV of those find NPV as difference between the PV of future cash flows and cost of the investment

According to Descartes' rule, conventional projects could have more than one IRR.

false

Conflicts between the NPV and IRR rules will occur when the projects' NPV profiles have a crossover point.

false

investing vs. financing CFs

financing- you're paying the IRR, initially receive cash then pay investing- common investment where you pay upfront then receive

disadvantages of the NPV

-complicated -requires a discount rate

calculating discounted payback

-estimate expected CFs -compute PV of each future CF -subtract PV of each future CF from the initial cost until the investment has been recovered on a discounted basis

You solve algebraically for the internal rate of return.

False

The IRR rule: If a project's IRR is greater than the opportunity cost of capital, then accept the project.

True

The NPV and IRR rules may conflict when mutually exclusive projects have substantially different initial investments.

True

IRR definition

attempting to find a single rate that summarizes the merits of the project internally aka only concernings CFs of the investment, not rates offered elsewhere required return (discount rate) that makes NPV 0 (because at NPV=0, we are breaking even financially and you're finding the rate if you're paying exactly what it's worth) discount rate that sets the PV of a project's inflows = to the PV of its outflows

what does the payback rule evaluate

the wrong thing- how long it takes to recover an initial investment instead of how an investment will affect the value of the stock

conditions for NPV/IRR to agree on accept/reject decisions

-CFs must be conventional -project must be independent also may be different if initial investments or timing of CFs are substantially different

disadvantages of payback rule

-ignores TVM -fails to consider risk -requires arbitrary cutoff point and there are no guidelines for setting cutoff number -biased toward ST investments -ignores CF past cutoff date -conventional projects ONLY

disadvantage of PI

-ignores scale -may lead to incorrect decisions in comparisons of mutually exclusive investments (tells the manager the value creates per dollar but doesn't account for how many dollars the projects require)

disadvantages of discounted payback

-not simpler than just finding NPV, complicated -requires arbitrary cutoff point -may reject positive NPV investments -biased against LT projects -ignores CFs past cutoff date -conventional projects only

advantages of IRR

-simpler to understand (rate vs. dollar amount) -don't need an appropriate discount rate to estimate (and if the IRR is high enough, you may not need to estimate a required return (VCs often do this)) -closely related to NPV

pros to the payback rule

-used with minor decisions (you can easily see if the benefits outweigh the losses) -simple -biased to liquidity which is important for small businesses (use when you're concerned about liquidity) -adjusts for riskiness of later cash flows (by ignoring them)

NPV/IRR/PI are

3 interpretations of the same equation

An advantage of discounted payback is that it does not reject positive NPV investments.

False

If a project has multiple IRRs, you implement the IRR rule by comparing the highest IRR to the required return. That's the value maximizing approach.

False

The profitability index measures the the value created in a project given the dollars invested, adjusting for the time value of money.

False

When faced with mutually exclusive projects, the profitability index is the "go to" rule.

False

where do you look to decide between multiple IRRs?

NPV profile note that when you pick different rates, you're emphasizing different points on a timeline. lower rates make later money more important

which rules account for the risk of the CFs?

NPV, IRR, PI, Payback (kind of), Discounted Payback (kind of)

PI calculation

PV of future CFs/Initial investment (this version is only applicable to conventional CFs but you can use if for nonconventional CFs too) PV inflows/PV outflows (don't need minus sign for outflows because it will always be positive) 1 + (NPV/Cost)

as required return increases, PV of inflows/outflows...

PV of inflows decreases and PV of outflows stays the same chance you're gonna reject increases

NPV rule

accept if (+) if the PV of cash inflows > PV of cash outflows, accept the project

IRR rule

accept if IRR > required return on our assets

discounted payback rule

accept if discounted payback period is less than some preset limit

choosing between projects with PI

always go PI to lowest and assume you can use fractional projects (use all your money up!)

payback period

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

NPV logic

an investment is worth undertaking if it creates value for its owners since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal

what is one thing all of the rules have in common

firm must begin capital budgeting process by estimating a project's CFs

PI of 1.1 implies

for every $1 of investment, we create an additional 0.10 in value

pre vs. post mortem

good firms do a post-mortem- comparing actual versus expected better firms do a pre-moretum- what assumptions are we missing? what disasters could happen?

NPV profile

graph that shows relationship between an investment's NPV (y axis) and various discount rates (x-axis) curve crosses x-axis at IRR

IRR and it's focus on early/later money

high rate focuses attention on early money low rate focuses attention on later money

as time increases, the estimation error of payback

increases

payback period for an annuity

initial cost/annual CF

payback rule

investment is acceptable if payback period is less than some prespecified number of years "break even" measure in an accounting (nominal) sense, not in an economic sense

profitability index definition

is a ratio also called benefit-cost ratio measures value created per dollar invested in a project, adjusting for TVM will be >1 for positive NPV investments and <1 for negative NPV investments

overall, why don't we just use NPV?

it's an estimate, and the others are clues to whether NPV is reliable

effects of payback rule shortcomings

leads people to take investments worth less than they already cost and leads people to reject profitable long-term investments

discounted payback

length of time until the sum of the DCFs = initial investment payback rule + adjustment for TVM "break even" measure in an economic (PV) sense

when they cross, where do NPV/IRR agree disagree

they disagree to left of crossover point and agree to right

how does the NPV/IRR account for risk?

through the required return rate

For a conventional project, NPV is the difference between the project's cost and the present value of its expected future cash flows.

true

IRR and Nonconventional CF

when the CFs change sign more than once, there could as many IRRs as there are sign changes

when should you use discounted payback?

when you're concerned about risk and have a high OC