FINA 2303 Chapter 9
Profitability Index Benefits
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
Internal Rate of Return Benefits
1) Closely related to NPV, often leading to identical decisions 2) Easy to understand and communicate
Average Accounting Return Benefits
1) Easy to Calculate 2) Needed Information will usually be available
Discounted Payback Period Benefits
1) Includes Time Value of Money 2) Easy to Understand 3) Does not accept negative estimated NPV investments 4) Biased towards liquidity
Profitability Index Shortcomings
1) May lead to incorrect decisions in comparisons of mutually exclusive investments
What defines the business of a firm?
Fixed Assets
Payback Period
The amount of time required for an investment to generate cash flows sufficient to recover its initial cost
Capital Budgeting Decision
The decision whether to invest in a factory or a new machine is a capital budgeting decision.
Net Present Value (NPV)
The difference between an investment's market value and its cost.
Internal Rate of Return (IRR)
The discount rate that makes the NPV of an investment zero
Discounted Payback Period
The length of time required for an investment's discounted cash flows to equal its initial cost
Multiple Rates of Return
The possibility that more than one discount rate will make the NPV of an investment zero
Profitability Index (PI)
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
Discounted Payback Period Shortcomings
1) May reject positive NPV investments 2) Requires arbitrary cutoff point 3) Ignores cash flows beyond the cutoff date. 4) Biased against long-term projects, such as research and development, and new projects
Internal Rate of Return Shortcomings
1) May result in multiple answers or not deal with nonconventional cash flows. 2) May lead to incorrect decisions in comparisons of mutually exclusive investments
Average Accounting Return Shortcomings
1) Not a true rate of return; time value of money is ignored. 2) Uses an arbitrary benchmark cutoff rate 3) Based on accounting (book) values, not cash flows and market values.
Payback Period Benefits
1) Simple and Basic - Minor Decisions 2) Investments that pay back rapidly and has benefits extending beyond the cutoff period probably has a positive NPV 3) Payback Period rule tends to favour investments that free up cash for other uses quickly
Payback Period Shortcomings
1) Time Value of Money is completely ignored 2) Fails to consider any risk differences 3) Cutoff period is set arbitrarily 4) Biased against long-term projects, such as research and development and new projects
Net Present Value Profile
A graphical representation of the relationship between an investment's NPV and various discount rates.
Mutually Exclusive Investment Decisions
A situation in which taking one investment prevents the taking of another.
Profitability Index Rule
Accept if >1, Reject if <1
Net Present Value Rule
An investment should be accepted if the net present value is positive and rejected if it is negative.
Average Accounting Return (AAR)
An investment's average net income divided by its average book value.
Internal Rate of Return Rule
Based on the IRR rule, an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.
Average Accounting Return Rule
Based on the average accounting return rule, a project is acceptable if its average accounting return exceeds a target average accounting return.
Discounted Payback Period Rule
Based on the discounted payback rule, an investment is acceptance if its discounted payback is less than some pre-specified number of years.
Payback Period Rule
Based on the payback rule, an investment is accepted or rejected if its calculated payback period is less than some pre-specified number of years
