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