Finance Ch. 9 Concepts Review

Describe how the discounted payback period is calculated, and describe the information this measure provides about a sequence of cash flows. What is the decision rule?

Calculated the same way as payback but each cash flow has to be set to present value. Accept projects whose discounted cash flows payback before cutoff period.

If IRR is equal to firm's required return, then it will neither _________ nor ________ wealth

Create; destroy

PI is computed using accounting income and accounting book values, true or false?

False

Describe how the IRR is calculated and describe the information this measure provides about a sequence of cash flows. What is the decision rule?

IRR is the discount rate where NPV=0. So it is a financial break even rate of return. Accept project if IRR is greater than discount rate.

What is the relationship between IRR and NPV? Where would you prefer one over the other?

IRR makes NPV=0. NPV is considered ideal compared to IRR and IRR shouldn't be used for nonconventional (more than one sign change) projects.

If a project with conventional cash flows has a payback period less than the project's life can you definitively state the algebraic sign of the NPV? If you know the discounted payback period is less than the project's life, what can you say about the NPV?

If a payback period is less than the project's life, that means NPV is positive for a zero discount rate. If we are using discounted payback, then NPV must be positive.

Suppose a project has conventional cashflows (only one sign change) and a positive NPV. What do you know about the payback? Discounted payback? Profitability index? IRR?

If a project has a positive NPV then the discounted payback period must be less than the project's life, the PI must be greater than 1, and the IRR is bigger than the rate of return.

What are the problems associated with using payback period to evaluate cash flows?

It does not take into account the TVM and is biased toward short term projects and ignores cash flows after cutoff period.

What are the problems associated with discounted payback?

It ignores all cashflows after the cutoff date.

What are the advantages of using payback period?

It is useful for simplicity and for projects that are biased toward liquidity.

What conceptual advantage does discounted payback method have over the regular payback method?

It takes into account the time value of money and is usually smaller than payback.

Why do most financial managers use IRR?

It's easy to communicate.

What is the relationship between profitability index and NPV? Are there situations you would prefer one over the other?

NPV is a dollar amount where PI is a ratio and cannot take into account the size of the cash flows. Do not use PI to compare mutually exclusive projects.

Describe how the NPV is calculated and describe the information this measure provides about a sequence of cash flows. What is the decision rule?

NPV is the present value of a project's cash flows. It measures the net increase or decrease in firm wealth due to a project. Accept project if NPV is positive.

Why is the NPV considered the superior method?

No serious flaws and it measures value creation and destruction aka the goal in our finance.

NPV index

PI - 1

Describe how the payback period is calculated and describe the information this measure provides about a sequence of cash flows. What's the payback criterion rule?

Payback period is the accounting break even point of a series of cash flows. Point in time where initial cash outflows are fully recovered. Accept project if payback period is less than your project's life.

The payback period will be shorter than the discounted payback period when

Projects have conventional cash flows and positive discount rates

Describe how the profitability index is calculated, and describe the information this measure provides about a sequence of cash flows. What is the decision rule?

The PI is the present value of inflows over outflows. It is a benefit/cost ratio providing a measure of the relative profitability of a project. Accept projects with a PI > 1