Chapter 9 Concepts

advantages to using payback period to evaluate cash flows?

Despite its shortcomings, payback is often used because (1) the analysis is straightforward and simple and (2) accounting numbers and estimates are readily available. Materiality considerations often warrant a payback analysis as sufficient; maintenance projects are another example where the detailed analysis of other methods is often not needed. Since payback is biased towards liquidity, it may be a useful and appropriate analysis method for short-term projects where cash management is most important.

what conceptual advantage does the discounted payback period over the normal payback period?

Discounted payback is an improvement on regular payback because it takes into account the time value of money. For conventional cash flows and strictly positive discount rates, the discounted payback will always be greater than the regular payback period.

why do most use IRR along with NPV when evaluating projects?

IRR is frequently used because it is easier for many financial managers and analysts to rate performance in relative terms, such as "12%", than in absolute terms, such as "$46,000." IRR may be a preferred method to NPV in situations where an appropriate discount rate is unknown are uncertain; in this situation, IRR would provide more information about the project than would NPV.

relationship between NPV and IRR? Situations where u may prefer the use of one to the use of the other

IRR is the interest rate that causes NPV for a series of cash flows to be zero. NPV is preferred in all situations to IRR; IRR can lead to ambiguous results if there are non-conventional cash flows, and it also ambiguously ranks some mutually exclusive projects. However, for stand-alone projects with conventional cash flows, IRR and NPV are interchangeable techniques.

How is NPV calculated? what does info does this give us about cash flows? what is the NPV criterion decision rule?

NPV is simply the present value of a project's cash flows. NPV specifically measures, after considering the time value of money, the net increase or decrease in firm wealth due to the project. The decision rule is to accept projects that have a positive NPV, and reject projects with a negative NPV.

Why is NPV considered a superior method of evaluating cash flows from a project? Drawbacks of NPV? if NPV is found to be $2500, what does this mean to the shareholders?

NPV is superior to the other methods of analysis presented in the text because it has no serious flaws. The method unambiguously ranks mutually exclusive projects, and can differentiate between projects of different scale and time horizon. The only drawback to NPV is that it relies on cash flow and discount rate values that are often estimates and not certain, but this is a problem shared by the other performance criteria as well. A project with NPV = $2,500 implies that the total shareholder wealth of the firm will increase by $2,500 if the project is accepted.

relationship between PI and NPV?

PI = (NPV + cost)/cost = 1 + (NPV/cost). If a firm has a basket of positive NPV projects and is subject to capital rationing, PI may provide a good ranking measure of the projects, indicating the "bang for the buck" of each particular project.

how is payback period calculated ? what does it tell us about series of cash flows?

Payback period is simply the accounting break-even point of a series of cash flows. To actually compute the payback period, it is assumed that any cash flow occurring during a given period is realized continuously throughout the period, and not at a single point in time. The payback is then the point in time for the series of cash flows when the initial cash outlays are fully recovered. Given some predetermined cutoff for the payback period, the decision rule is to accept projects that payback before this cutoff, and reject projects that take longer to payback.

How is IRR calculated? what is the IRR decision rule?

The IRR is the discount rate that causes the NPV of a series of cash flows to be exactly zero. IRR can thus be interpreted as a financial break-even rate of return; at the IRR, the net value of the project is zero. The IRR decision rule is to accept projects with IRRs greater than the discount rate, and to reject projects with IRRs less than the discount rate.

how is discounted payback period calculated? what is the discounted payback criterion rule?

The discounted payback is calculated the same as is regular payback, with the exception that each cash flow in the series is first converted to its present value. Thus discounted payback provides a measure of financial/economic break-even because of this discounting, just as regular payback provides a measure of accounting break-even because it does not discount the cash flows. Given some predetermined cutoff for the discounted payback period, the decision rule is to accept projects whose discounted cash flows payback before this cutoff period, and to reject all other projects.

what are the problems with using discounted payback period to evacuate cash flows?

The primary disadvantage to using the discounted payback method is that it ignores all cash flows that occur after the cutoff date, thus biasing this criterion towards short-term projects. As a result, the method may reject projects that in fact have positive NPVs, or it may accept projects with large future cash outlays resulting in negative NPVs. In addition, the selection of a cutoff point is again an arbitrary exercise.

How is profitability index calculated? what is the decision rule?

The profitability index is the present value of cash inflows relative to the project cost. As such, it is a benefit/cost ratio, providing a measure of the relative profitability of a project. The profitability index decision rule is to accept projects with a PI greater than one, and to reject projects with a PI less than one.

biggest issue with capital budgeting

The single biggest difficulty, by far, is coming up with reliable cash flow estimates. Determining an appropriate discount rate is also not a simple task. These issues are discussed in greater depth in the next several chapters. The payback approach is probably the simplest, followed by the AAR, but even these require revenue and cost projections. The discounted cash flow measures (discounted payback, NPV, IRR, and profitability index) are really only slightly more difficult in practice.

what are the problems associated with using the payback period to evaluate cash flows?

The worst problem associated with payback period is that it ignores the time value of money. In addition, the selection of a hurdle point for payback period is an arbitrary exercise that lacks any steadfast rule or method. The payback period is biased towards short-term projects; it fully ignores any cash flows that occur after the cutoff point.

if a project has a payback period less than the projects life, can you state the sign of the NPV? What does this mean for discount rates?

Yes, a payback period less than the life of the project means that the NPV is positive for discount rates > 0, the payback period will be less than the projects life, but NPV could be positive, negative, or 0 dependent upon whether the discount rate is >,<,= to the IRR

Suppose a project has conventional cash flows and a +NPV. What do you know about its payback? discounted payback? Profitability index? IRR?

payback+discounted payback: because NPV is positive, we can conclude that both of these periods are less than the project life Profit index: if NPV is +, then the PV for future cash flows is greater than the initial investment cost, so PI is >1 IRR: greater than required rate of return since NPV is positive at discount rate R