FINC Chapter 9 Concepts

Describe how NPV is calculated, and describe the information this measure pro-vides about a sequence of cash flows. What is the NPV criterion 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.

Describe how the IRR is calculated, and describe the information this measure provides about a sequence of cash flows. What is the IRR criterion 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? Are there any situations in which you might prefer one method over the other? Explain.

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? Why or why not? If you know that the discounted pay-back period is less than the project's life, what can you say about the NPV? Explain.

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 cash flows and a positive NPV. What do you know about its payback? Its discounted payback? Its profitability index? Its IRR? Explain.

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 the 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 advantages of using the payback period to evaluate cash flows? Are there any circumstances under which using payback might be appropriate? Explain.

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

Despite its shortcomings in some situations, why do most financial managers use IRR along with NPV when evaluating projects? Can you think of a situation in which IRR might be a more appropriate measure to use than NPV? Explain.

It's easy to communicate.

What is the relationship between the profitability index and NPV? Are there any situations in which you might prefer one method over the other? Explain.

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.

Why is NPV considered a superior method of evaluating the cash flows from a project? Suppose the NPV for a project's cash flows is computed to be $2,500. What does this number represent with respect to the fi rm's shareholders?

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

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

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