Chapter 8
The basic NPV investment rule is:
-accept a project if the NPV is greater than zero -reject a project if its NPV is less than zero -if the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference
The multiple rates of return problem is the possibility that more than one discount rate may make the net present value of an investment equal to
0
The PI rule for an independent project is to ______ the project if the PI is greater than 1.
accept
One of the weaknesses of the payback period is that the cutoff date is a(n) ______ standard.
arbitrary
The Profitability Index is also called the __________ ratio.
cost-benefit
Disadvantage of PI
it cannot rank mutually exclusive projects
The discounted cash flow valuation shows that higher cash flows earlier in a project's life are ______ valuable than higher cash flows later on.
more, Present value is inversely related to time. Cash flows earlier in the project life are more valuable as they can be reinvested.
In capital budgeting, ______ determines the dollar term-1value of a project to the company.
net present value
Problems when using IRR
non-conventional cash flows mutually exclusive projects
One of the flaws of the payback period method is that cash flows after the cutoff date are
not considered in the analysis
The ______ method evaluates a project by determining the time needed to recoup the initial investment.
payback
According to the basic IRR rule, we should:
reject a project if the IRR is less than the required return
Internal rate of return (IRR) must be compared to the ________ in order to determine the acceptability of a project.
required return
Net Present Value
the difference between an investment's market value and its cost NPV=(PV of FCF - PV of Project Cost)
Internal Rate of Return
the discount rate that makes the NPV of an investment zero
The payback Rule
the length of time it takes to recover our initial investment
discounted cash flow (DCF) valuation
the process of valuing an investment by discounting its future cash flows
A project with non-conventional cash flows will produce two or more IRRs.
true
The spreadsheet function for calculating net present value is
NPV(rate,CF1, ..., CFn) + CF0
Profitability Index
Net Present Value / Investment Required
Reasons why IRR continues to be used in practice
The IRR of a proposal can be calculated without knowing the appropriate discount rate. Businesspeople prefer to talk about rates of return. It is easier to communicate information about a proposal with an IRR.
What are the advantages for the payback period method for management?
The payback period method is ideal for minor projects. It allows lower level managers to make small decisions effectively. The payback period method is easy to use.
Excel NPV function differs from the manner in which they are entered in a financial calculator by:
The range of cash flows specified in Excel begins with Cashflow 1, not Cashflow 0. The discount rate in Excel is entered as a decimal, or as a percentage with a percent sign. With the Excel NPV function, Cashflow 0 must be handled outside the NPV function. The Excel NPV function is actually a PV function.
Some projects, such as mines, have cash outflows followed by cash inflows and cash outflows again, giving the project multiple internal rates of return.
True
When calculating NPV, the present value of the nth cash flow is found by dividing the nth cash flow by 1 plus the discount rate raised to the nth power.
True
The internal rate of return is a function of
a project's cash flows
