Chapter 9 - T/F
An advantage of discounted payback is that it is simple.
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The NPV rule is the most commonly used capital budgeting tool in practice.
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The discounted payback rule accounts for the time value of money.
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You solve algebraically for the profitability index.
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A disadvantage of payback is that it adjusts for the time value of money.
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A disadvantage of the internal rate of return is that you cannot calculate it without a required a required return.
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A project with a PI of 1.00 creates $1.00 of additional value for every dollar invested in the project.
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An advantage of discounted payback over nominal payback is that it does not reject positive NPV projects.
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An advantage of payback is that it ignores cash flows beyond the cutoff date, regardless of how big they are.
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An advantage of payback is that it is biased against liquidity.
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An advantage of the profitability index is that PI is closely related to the discounted payback rule.
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Descarte's rule states that there are as many roots of a polynomial as there are sign changes in its terms.
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For a conventional project, the profitability index for a project is the initial cost divided by the present value of the inflows .
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If mutually exclusive projects have NPV profiles that cross, then the NPV and IRR rules will conflict.
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If mutually exclusive projects have NPV profiles that do not cross, then the NPV and IRR rules will conflict.
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Mutually exclusive projects are ones where pursuing one projects financially precludes doing another project.
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NPV profiles that cross for mutually exclusive projects do so because the timing of the projects' cash flows are similar.
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Payback Procedure: 1. Estimate a project's expected future cash flows. 2. Subtract the future cash flows from the initial cost until company recovers the initial investment. 3. Accept if the payback period is longer than the preset limit. Reject if the payback period is less than the preset limit.
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Payback is a good capital budgeting rule for a company like Boeing that invests in expensive long-term projects.
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The NPV rule: If the NPV is negative, reject the project because it will increase the stock's price.
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The payback rule is, accept a project if the payback period is more than some preset limit.
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The profitability index is a capital budgeting tool used most often when a company is faced with mutually exclusive projects.
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The profitability index measures the value created per dollar invested in a project, without adjusting for the time value of money.
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When evaluating mutually exclusive projects, if the NPV and IRR rules conflict you sometimes use NPV, and other times use IRR. It depends.
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You solve for the net present value through trial and error.
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A conventional project has a smoothly declining NPV profile that crosses the x-axis only once.
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A disadvantage of discounted payback is that it is biased against long-term projects.
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A disadvantage of discounted payback is that it may reject positive NPV projects.
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A disadvantage of payback is that it is biased against long-term projects.
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A disadvantage of payback is that it requires an arbitrary cutoff point.
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A disadvantage of payback is that there is not a strong theoretical basis for the preset limit.
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Companies should avoid investing in projects that have a profitability index less than one.
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For a conventional project, the profitability index for a project is the present value of the inflows divided by the initial cost.
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For conventional projects, the present value of the outflow does not change when the discount rate changes.
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IRR Procedure: 1. Estimate a project's expected future cash flows. 2. Use trial and error to find the IRR, which is the rate of return that sets PI of the project equal to one. 3. Accept if the IRR is higher than the rate of on the next best investment of similar risk.
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Mutually exclusive projects are common when developing real estate.
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NPV Procedure: 1. Estimate a project's expected future cash flows. 2. Using the required return, subtract the present value of all the cash outflows from the present value of all the cash inflows. 3. Accept if the present value of the inflows is greater than the present value of the outflows.
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NPV and IRR will generally give the same accept or reject decison except when there are mutually exclusive projects. They may conflict in this situation.
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Payback is not a good capital budgeting rule for a company like Pfizer that invests in expensive long-term drug research, testing, and manufacturing.
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The NPV rule: If the NPV is negative, reject the project because it will destroy value for the shareholders.
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The NPV rule: If the NPV is positive, accept the project because it will increse the share price.
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The discounted payback rule does not provide an indication as to how the stock price will change if the company accepts the project under consideration
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The payback period is how long it takes a business to recover the initial cost of a project in a nominal sense.
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When solving for the crossover rate: 1. Set the NPVs of the two projects equal. 2. Collect terms on one side of the equality. 3. Enter the difference in the projects' cash flows into your TI's cash flow function at each point in time. 4. Use the IRR function to solve through trial and error for the rate that sets the NPVs equal.
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