Finance Ch. 8

What is an average accounting return (AAR)?

An investment's average net income divided by its average book value. book value= 500,000+0/2=250000, avg net income=50000 50000/250000 = 20%

Why do we say that the payback period is, in sense, an accounting break-even measure?

Because time value if ignored, you can think of the payback period as the length of time it takes to break even in an accounting sense, but not in an economic sense.

Is it generally true that an advantage of the IRR rule of the NPV rule is that we don't need to know the required return to use the IRR rule?

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Since NPV is conceptually the best tool for capital budgeting, why do you think multiple measures are used in practice?

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Under the circumstanceswill the IRR and NPV rules lead to the same accept-reject decisions? Why might they conflict?

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What is the net present value profile?

A graphical representation of the relationship between an investment's NPV and various discount rates.

How would you state the profitability index rule?

A project is acceptable if

What is the average accounting return rule?

A project is acceptable if its average accounting return exceeds a target average accounting return.

What are Mutually exclusive investment decisions?

A situation where taking one investment prevents the taking of another.

What is the payback period rule?

An investment is acceptable if its calculated payback period is less than some prespecified number of years. It is biased towards short-term projects and it is biased towards liquidity.

What is the net present value rule?

An investment should be accepted if the net present value is positive and rejected if it is negative

What are the most commonly used capital budgeting procedures?

IRR or NPV

What are the weaknesses of the AAR rule?

It is not a true rate of return because the time value of money is ignored. It uses an arbitrary benchmark cutoff rate. Lastly, it is based on accounting net income and book values, not cash flows and market values.

If we say an investment has an NPV of $1000, what exactly do we mean?

It means that the cost of obtaining the cash flows for an investment have been subtracted from the expected cash flows which gives us the NPV of $1000 which is positive so we should move forward with it.

What is a payback period?

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

What is net present value?

The difference between an investments market value and its cost.

What is the internal rate of return (IRR)?

The discount rate that makes the NPV of an investment zero.

What are multiple rates of return?

The possibility that more than one discount rate makes the NPV of an investment zero.

What is the profitability index?

The present value of an investment's future cash flows divided by its initial cost. Also, benefit-cost ratio.

What is discounted cash flow valuation?

The process of valuing an investment by discounting its future cash flows.