FIN 320 CH. 8

Modified Internal Rate of Return (MIRR)

-controls for some problems with IRR -MIRR will be a unique number for each method -Mangers like rate of return comparisons and this is better for this than IRR 3 methods: 1. Discounting approach - discount future outflows to present and add to CF0 2. Reinvestment approach - compound all cash flows except the first one forward to end 3. Combination approach - discount outflows to present; compound inflows to end

net present value (NPV)

-difference between an investment's market value and its cost -the measure of how much value is created or added today by undertaking an investment (can be done on calc. Simply put in Cash Flows (CF0 is the cost of the investment make sure it is negative), put in the required return, then hit orange NPV for answer)

Average Accounting Return (AAR)

-many different definitions -in this book: = Avg. net income / Avg. Book value -requires a target cutoff date *note: Avg. book value depends on how the asset is depreciated

Profitability index

-measures the benefit per unit cost, based on the time value of money -a profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in NPV in value -can be useful in situations of capital rationing

Internal Rate of Return (IRR)

-most important alternative to NPV; widely used in practice -based entirely on the estimated cash flows; independent of interest rates -it is the discount rate that makes NPV = 0 On calc. : Enter cash flows (CF0 is negative, it is the cost of the investment.) then hit orange IRR/Yr for answer

Mutually exclusive projects

-the acceptance of 1 project precludes accepting the other

Independent projects

-the cash flows of 1 project are unaffected by the acceptance of the other

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

Disadvantages of IRR

1. Can produce multiple answers 2. Cannot rank mutually exclusive projects 3. Reinvestment assumption flawed

Advantages of profitability index

1. Closely related to NPV, generally leading to identical decisions: considers all cash flows, TVM 2. Easy to understand & communicate 3. Useful in capital rationing

Capital Budgeting in Practice (4)

1. Consider all investment criteria when making decisions 2. NPV & IRR are the most commonly used primary investment criteria 3. Payback is a commonly used secondary investment criteria 4. All provide valuable information

Advantages for AAR

1. Easy to calculate 2. Needed information usually available

Advantages to payback period

1. Easy to understand 2. Adjusts for uncertainty of later cash flows 3. Biased towards liquidity (aka short term projects)

Disadvantages to payback period

1. Ignores the time value of money 2. Requires an arbitrary cutoff point 3. Ignores cash flows beyond the cutoff date 4. Biased against long-term projects *Asks the wrong question!: The relevant issue is the impact an investment will have on the value of our stock, not how long it takes to recover the initial investment.

Disadvantages of profitability index

1. May lead to incorrect decisions in comparisons of mutually exclusive investments (can conflict with NPV)

Disadvantages for AAR

1. Not a true rate of return 2. Time value of money ignored 3. Uses an arbitrary benchmark cutoff rate 4. Based on accounting net income and book values, not cash flows and market values *does not tell us what we want to know

Advantages of IRR

1. Preferred by executive: intuitively appealing, easy to communicate the value of a project 2. If the IRR .is high enough, may not need to estimate a required return 3. Considers all cash flows 4. Considers the time value of money 5. Provides indication of risk

2 reasons NPV Profiles cross

1. Size (scale differences) - smaller project frees up funds sooner for investment -the higher the opportunity cost, the more valuable these funds, so high discount rate favors small projects 2. Timing differences -project with faster payback provides more cash flow in early years for reinvestment -if discount rate is high, early cash flows especially good

2 exceptions of IRR that won't work but WILL work with NPV

1. non-conventional cash flows - cash flow sign changes more than once 2. mutually exclusive projects - initial investments are substantially different -timing of cash flows is substantially different

Decision rule for AAR

Accept the project if the AAR is greater than the target rate

Decision rule for IRR

Accept the project if the IRR is greater than the required return

The net present value profile illustrates how the net present value of an investment is affected by which one of the following?

Discount rate

Which one of the following defines the internal rate of return for a project?

Discount rate which results in a zero net present value for the project

Decision rule for profitability index

If P1 > 1.0, accept.

Which one of the following statements is true?

If the internal rate of return equals the required return, the net present value will equal zero.

Which one of the following is most closely related to the net present profile?

Internal rate of return

Which one of the following indicates that a project is expected to create value for its owners?

Positive net present value

You are using a net present profile to compare investments A & B, which are mutually exclusive. Which one of the following statements correctly applies to the crossover point between these two?

The net present value of project A equals that of project B, but generally does not equal zero.

Which one of the following will occur when the internal rate of return equals the required return?

The profitability index will equal 0.

True or False: A project with non-conventional cash flows will produce 2 or more IRRs.

True

True or false: When the internal rate of return is greater than the required return, the net present value is positive.

True

What does NPV = 0 mean?

We would be indifferent to the project.

Decision rule for NPV

When NPV is positive, accept the project.

payback period

answers: how long does it take to recover the initial cost of a project? -"break-even measure" 1. Add the 1st year cash flow to the initial investment price and keep adding cash flows until the cumulated cash flow = 0. (look at ch 8 problems #1 and study)

The net present value:

decreases as the required rate of return increases

Discounted cash flow valuation is the process of discounting an investment's

future cash flows

NPV is a direct measure of...

how well this project will meet the goal of increasing shareholder wealth.

The NPV is ___ if the required return is less than the IRR, and it is ___ if the required return is greater than the IRR.

positive, negative

Decision rule for payback period

we accept if the payback period is less than some preset limit (in years)