Ch. 8

Disadvantages of payback method

- It ignores the time value of money - It ignores all information that occurs after the payback period has been reached -ignores risk -biased against long-term projects

Advantages of NPV

-considers the TVM of the cash flows -considers the risk by using risk-adjusted discount -allows for comparison of projects with different cash flows and different risk levels

Advantages of Profitability Index

-consistent with TVM (typically leads to same decisions are NVP -incorporates risk via required rate of return -standardizes NPV in relation to each $1 invested

Disadvantages of Profitability Index

-difficult to accurately forecast the cash flows and the discount rate -problems of scale may give conflicting accept/reject decision if projects are mutually exclusive

Advantages of payback method

-easy to calculate -useful for small projects or for firms with limited access to capital -may allow management to see in a short time whether cash flow estimates are accurate

Reasons for capital rationing

-firm is unable to raise required finance -firm does not have enough qualified managers to run the project -company management is pessimistic about the economy (holding cash) -other intangible reasons like fear of incurring debt or unwillingness to issue more stocks

Capital Rationing

-limiting the amount of new capital investment -doesn't support the goal of the firm

Factors that influence risk

1. size of the project (risk of total loss of $1 is less than total loss of $1000) 2. length of the project (longer the project = greater the chance estimates are incorrect) 3. experience or knowledge (more uncertainty = higher required rate of return)

Which one of the following statements is correct?

If the internal rate of return equals the required return, the net present value will equal zero.

The payback period __________ the time value of money.

Ignores

Which one of the following indicates that a project is expected to create value for its owners?

Positive net present value

Payback Method

Reveals the length of time to recover the firm's initial outlay in a new project.

The internal rate of return is unreliable as an indicator of whether or not an investment should be accepted given which one of the following?

The investment is mutually exclusive with another investment of a different size.

An investment has conventional cash flows and a profitability index of 1.0. Given this, which one of the following must be true?

The net present value is equal to zero.

Scenario Analysis

change assumptions of performance nd calculate NPV based on each case

Decision criteria for payback

if projects are INDEPENDENT --> choose all projects with a PAYBACK PERIOD LESS THAN OR EQUAL TO SOME PREDETERMINED LENGTH OF TIME if projects are EXCLUSIVE --> choose the one with the SHORTEST PAYBACK THAT FITS WITHIN THE PAYBACK WINDOW

Decision Criteria for PI

if projects are INDEPENDENT --> choose all projects with a PI ABOVE 1 if projects are MUTUALLY EXCLUSIVE --> choose the ones with the HIGHEST PI

Sensitivity Analysis

isolates one variable and determine change resulting from changes in this one item

Disadvantages of NPV

its based on estimates

The steeper the curve of the NPV at various discount rates means what?

the more sensitive the project is to changes in the discount rate

Internal Rate of Return (IRR)

what interest rate of future cash flows would you get to break even

NEGATIVE Npv

will DECREASE value in the firm IRR will be LESS than discount rate

POSITIVE NPV

will INCREASE value in the firm IRR will be MORE than the discount rate

If an investment is producing a return that is equal to the required return, the investment's net present value will be:

zero

Net Present Value (NPV)

-represents a project's overall effect on the value of a firm -also known as "discounted cash flow method"

Profitability Index

-states the present value of the project in terms of the value of each dollar invested -for each $1 we invest we'll receive that amount in return

Advantages of IRR

-used by investors because its easy to understand -allows for the comparison of projects with different levels of risks

Which one of the following statements is correct? Assume cash flows are conventional.

When the internal rate of return is greater than the required return, the net present value is positive.

The net present value:

decreases as the required rate of return increases.

The internal rate of return is the:

discount rate that results in a zero net present value for the project.

The lower the discount rate= ________ the NPV

higher

Decision criteria for NPV

if projects are INDEPENDENT (resources aren't a problem) --> accept all project with NPV GREATER THAN ZERO if projects are DEPENDENT (resources are limited) --> choose the one with HIGHEST NPV