Finance Chapter 9
The discounted payback period of a project will decrease whenever the
Amount of cash inflows is increased
The discounted payback rule may cause
some positive net present value projects to be rejected.
Payback Period
the amount of time required for an investment to generate cash flows sufficient to recover its initial cost
Net Present Value (NPV)
the difference between an investment's market value and its cost Pv of cash inflows less Pv of cash outflows Estimate the req return for projects
Discounted Payback Period
the length of time required for an investment's discounted cash flows to equal its initial cost
Profitability Index
the present value of an investment's future cash flows divided by its initial cost
discounted cash flow (DCF) valuation
the process of valuing an investment by discounting its future cash flows
A project has a required payback period of three years. In this case the
Cash flow in year two is valued just as highly as the cash flow in year one
All else equal, the payback period for a project will decrease whenever the
Cash inflows are adjusted such that they occur sooner
Crossover
Compute irr
The advantages of the payback method of project analysis include the
Bias toward liquidity Ease of use (2 and 3)
What increases the net present value of a project
Decreasing the required rate of return
Capital Budgeting Decision
Have long term effects on a firm
The internal rate of return
Ignored the initial investment in a project Is the rate that causes the net present value of a project to equal zero (2&3)
The reason internal rate of return method of analysis is bad
Is because it may lead to incorrect decisions when comparing mutually exclusive projects
When net present value is positive
It creates value for a firms owners
Discounted payback is used less frequently than payback because
It included time value of money calculations
According to the payback rule a project is acceptable when the payback period is
Less than the pre-specified period
profitability index is closely related to
NPV
A project is accepted when
NPV>0, is positive
Assuming that straight line depreciation is used, the average accounting return for a project is computed as the average
Net income of a project divided by the average instrument in a project
The Irr tends to be
One of the two most frequently used methods of project analysis
The final decision on which project to use is based upon
Required rate of return
Payback is frequently used to analyze independent projects because:
The cost of an analysis is less than the potential loft from a faulty decision
Internal Rate if Return (IRR)
The discount rate that makes the net present value of an investment exactly equal to zero
Net present value is
The preferred method of analyzing a project even though the cash flows are only estimates And should be used when deciding between mutually exclusive projects
Irr will increase if
The salvage value of the assets utilized by the project is increased
Elements of IRR analysis
The timing of cash flows The rate designated as the minimum acceptable rate of return for a project The amt of each cash flow (1,3,4)
Reviewing a project from a cost benefit perspective
Use the profitability index
Accept profitability index
When greater than >1
Mutually exclusive investment decision
a situation in which taking one investment prevents the taking of another Always base decision off of NPV
If a project has a net present value equal to zero, then:
any delay in receiving the projected cash inflows will cause the project's NPV to be negative.
What is an example of a capital budgeting decision
deciding whether or not to a new product should be produced