chapter 8 finance: NPV
Why do we say that the payback period is, in a sense, an accounting break-even measure?
Because time value if ignored, you can think of the payback period as the length of time it takes to break even in an accounting sense, but not in an economic sense.
Average Accounting Return Rule
Based on the average accounting return rule, a project is acceptable if its average accounting return exceeds a target average accounting return.
payback period
The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.
Advantages of IRR
correlates with NPV easy to undertsand and communicate
Disadvantages of payback period rule
ignores time value of money requires cutoff point ignores cash flows after cutoff date biased against long term projects
Disadvantages of PI
may lead to incorrect decisions in comparisons of mutually exclusive decisions
Disadvantages of IRR
may result in multiple answers with nonconventional cash flows may lead to incorrect decisions in mutually exclusive investment decisions
Discounted Cash Flow Valuation
(a) Valuation calculating the present value of a future cash flow to determine its value today. (b) The process of valuing an investment by discounting its future cash flows.
Mutually exclusive investment decisions
A situation where taking one investment prevents the taking of another.
Advantages of PI
Closely related to NPV, generally leading to identical decisions. Easy to understand and communicate may be useful when available investments are limited
Multiple rates of return
The possibility that more than one discount rate will make the net present value of an investment zero.
Net Present value
The difference between an investment's market value and its cost. An investment should be accepted if the net present value is positive and rejected if it is negative.
Npv=0
investment is economically a break-even proposition when the NPV is zero because value is neither created nor destroyed.
Advantages of AAR
easy to calculate needed info will usually be available
Advantages of Payback period Rule
easy to understand adjusts for uncertainties of later cash flows biased towards liquidity
Irr Rule
Based on the IRR rule, an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.
Profitability Index
The present value of an investment's future cash flows divided by its initial cost. Also benefit-cost ratio The profitability index is defined as the PV of the cash inflows divided by the PV of the cash outflows
Disadvantages of AAR
not a true rate of return uses an cutoff rate based on accounting net income and book values, not cash flows and market values
How would you state the profitability index rule?
If the profitability index or ratio is greater than 1, the project is profitable and may receive the green signal to proceed. Conversely, if the profitability ratio or index is below, the optimum course of action may be to reject or abandon the project.
IRR
The discount rate that makes the net present value of an investment zero. The IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate.
What does the profitability index measure?
is the ratio of payoff to investment of a proposed project.
Average Accounting Return
An investment's average net income divided by its average book value.
Payback Rule
Based on the payback rule, an investment is acceptable if its calculated payback period is less than some pre-specified number of years.
If we say an investment has an NPV of $1,000, what exactly do we mean?
It's market value is 1000 above costs. It will increase stock value by 1000.
What is the NPV rule?
rule stating that an investment should be accepted if its net present value is greater than zero and rejected otherwise. According to the theory of net present value (NPV), participating in a positive NPV project will increase firm or shareholder wealth.
