Chapter 7: Investment Decision Rules Concept
What is the internal rate of return
-most important alternative to the NPV method -summarizes the merit of the project - Does not depend on the various interest rates prevailing in the capital markets
What are the problems with AAR
1. Accounting numbers are arbitrary 2. Takes no accounty of timing 3. Arbitrary cutoff date
List the three steps of the Average Accounting Return Method
1. Determine average net income 2. Determine average investment - divide by the # of years + 1 because of beginning of 5 years - sum of all residual value post depreciation divided by the number of years plus 1 3. Determining AAR - Average Net Income/ Average Investment
What are the problems with Payback Period Method
1. Doesn't take time value of money into consideration 2. Payments after the Payback period. They will be overlooked because of the short term orientation 3. No comparable guide for payback period
What is the payback period method
1. Initial outflow 2. Cut off period is however many years it takes to recover the initial outflow
what are the 3 key attributes to NPV
1. Uses cash flow 2. Uses all of the cash flow of the project 3. NPV discounts cash flows properly
What do you do when there are multiple rates of return
1. accept only projects with discount rates that yield positive NPV 2. CF is discounted and combined until there is one change of signs
What is the general rule with IRR
Accept the project if IRR is greater than the discount rate. Reject the project if IRR is less than the discount rate
What is the relationship between IRR and NPV
IRR is the rate that causes the NPV of the project to be zero
What is the formula for profitability index
PV of CF after initial investment/ Initial investment
What is the Cut off period
Payback period method's # of years it takes to match the initial cash outflow
What is Profitability Index
Ratio of the present value of future expected cash flows after the initial investment DIVIDED by the initial investment
What are the problems for mutually exclusive projects?
Scale
What is Discounted Payback Period Method?
Variation of the payback period method. Takes time value of money into consideration
What is the general rule for NPV
accept if NPV is over 0 and reject if NPV is less than 0
What is the general rule for PI
accept if greater than 1, reject if less than 1
Independent
accepting and rejecting a project is independent of acceptance and rejection of other projects
What is value additivity
contribution of any project to a firm's value is the NPV of the project. not true for other
What would Payback Period Method be good for?
small decisions
For discounted payback period method, as long as CF is positive, discount payback period will never be __________ than payback period
smaller
What is capital budgeting
the decision making process for accepting or rejecting projects
What happens with IRR rule when it's financing instead of investing?
the rule is reversed. you accept a project if the IRR is less than the discount rate
Dollar received _______ is worth ______ than the dollar received ____________
today, more, tomorrow
Mutually exclusive
you can build an apartment or a hotel, but you can't do both on the same lot