fin ch 9
if a project ever pays back on a discounted basis, it's NPV will be
+
disadvantages of the IRR
-can lead to multiple rates of return with nonconventional CFs (want NPV to be positive between the multiple rates) -ignores scale -may lead to incorrect decisions when comparing mutually exclusive investments (because it ignores scale) -doesn't tell manager how much value a project will add, it just gives the return per dollar
advantages of discounted payback
-includes TVM -doesn't accept projects with a negative NPV -biased towards liquidity -simple -doesn't accept non conventional projects
Mutually exclusive projects have NPV profiles that do not cross.
False
Nominal payback ignores the time value of money and does not adjust for risk.
False
The NPV rule does not adjust for the riskiness of a project's cash flows.
False
The profitability index is useful when corporations try to decide between mutually exclusive projects.
False
You must be careful when faced with mutually exclusive projects because the NPV and IRR rules will conflict.
False
An advantage of discounted payback is that it does not accept negative NPV investments when a project's cash flows are unconventional.
False- CONVENTIONAL
A conventional project has a smoothly increasing NPV profile that crosses the x-axis only once.
False- DECREASING
If your PI is one, the rate you're using is the
IRR
which rules provide an indication about the increase in value?
NPV
crossover point
the discount rate at which the NPVS of two projects are equal if a crossover point exists, there is a range of discount rates where the NPV and IRR rules conflict conflict arises when the required return is higher than the crossover point
A conventional project has a smoothly declining NPV profile that crosses the x-axis only once.
True
For conventional projects, there is an inverse relationship between the present value of the inflows and the discount rate.
True
Mutually exclusive projects do not have to have a crossover point.
True
PI Procedure: 1. Estimate a project's expected future cash flows. 2. Using the required return, divide the present value of all the cash inflows by the present value of all the cash outflows. 3. Reject if the profitability index is less than one.
True
PI adjusts for TVM
True
The NPV rule: If the NPV is negative, reject the project because it will decrease the stock's price.
True
The discounted payback rule severely adjusts for the risk of a project's cash flows because it does so two ways.
True
When looking at two NPV profiles that cross, if the required return is to the left of the crossover point, then the NPV and IRR rules will disagree.
True
mutually exclusive
taking one investment prevents the taking of another physical constraint *always choose one with highest NPV
NPV definition
the difference between an investment market value and its cost how much value is created today by undertaking an investment
Which of the following capital budgeting rules are biased towards liquidity? A. payback. B. net present value C. profitability index D. discounted payback E. internal rate of return F. None of these rules is
A,D
when r is infinity, NPV is
CF today
minimum growth rate is where
NPV = 0
NPV index and PI
NPV Index = PI - 1
with conventional cash flows, when r increases
NPV decreases
conflicts between NPV/IRR
NPV directly measures increase in value to firm do always use NPV in conflict (though IRR is #1 in real world) IRR is unreliable with nonconventional CFs and mutually exclusive projects
inflows/outflows in NPV
NPV is PV inflows - PV outflows PV outflows is what you're paying and PV inflows is what it's worth don't pay more than what something is worth, that's value destroying
which rules account for TVM?
NPV, IRR, PI, Discounted Payback
conventional project
a project with an initial cash outflow followed by future cash inflows
Descartes' rule
property of polynomials says that there could be as many IRRs as there are sign changes for a project's CFs
IRR ignores
scale
fundamental business decisions
capital budgeting is the most important question of finance the most fundamental decisions a business can make concerns its product lines
finding the crossover rate
compute the irr on the difference of the cash flows
finding the crossover rate
set NPVs equal collect terms on one side (find differences between project CFs) use CF function to find IRR (but note that that is your crossover rate NOT an IRR)
good decision criteria
does the decision rule adjust for the TVM? does the decision rule adjust for risk? does the decision rule provide information on whether we are creating value for the firm?
biggest advantage of PI
may be helpful when available investment funds are limited (use to try and allocate scarce resources) also, doesn't accept negative NPV projects
in the real world, where do firms put most of their energy?
mostly step 1- estimating expected CFs and determining the right OC
can a conventional project have multiple IRRs?
no
do financial constraints indicate mutual exclusivity?
no FC is a CF constraint ME is a physical constraint
if it doesn't pay back in normal payback, will it payback with discounted?
no, discounted is always later
non-conventional project
outflows are not characterized by a single initial expenditure
questions to find how much value is created from undertaking an investment?
estimate expected future CFs estimate the required return for projects of this risk level find the PV of all the cash inflows/outflows and add them up
calculating payback
estimate expected future CFs subtract future CFs from initial cost until initial investment has been recovered
estimating NPV
estimate future CFs use DCF to find PV of those find NPV as difference between the PV of future cash flows and cost of the investment
According to Descartes' rule, conventional projects could have more than one IRR.
false
Conflicts between the NPV and IRR rules will occur when the projects' NPV profiles have a crossover point.
false
investing vs. financing CFs
financing- you're paying the IRR, initially receive cash then pay investing- common investment where you pay upfront then receive
disadvantages of the NPV
-complicated -requires a discount rate
calculating discounted payback
-estimate expected CFs -compute PV of each future CF -subtract PV of each future CF from the initial cost until the investment has been recovered on a discounted basis
You solve algebraically for the internal rate of return.
False
The IRR rule: If a project's IRR is greater than the opportunity cost of capital, then accept the project.
True
The NPV and IRR rules may conflict when mutually exclusive projects have substantially different initial investments.
True
IRR definition
attempting to find a single rate that summarizes the merits of the project internally aka only concernings CFs of the investment, not rates offered elsewhere required return (discount rate) that makes NPV 0 (because at NPV=0, we are breaking even financially and you're finding the rate if you're paying exactly what it's worth) discount rate that sets the PV of a project's inflows = to the PV of its outflows
what does the payback rule evaluate
the wrong thing- how long it takes to recover an initial investment instead of how an investment will affect the value of the stock
conditions for NPV/IRR to agree on accept/reject decisions
-CFs must be conventional -project must be independent also may be different if initial investments or timing of CFs are substantially different
disadvantages of payback rule
-ignores TVM -fails to consider risk -requires arbitrary cutoff point and there are no guidelines for setting cutoff number -biased toward ST investments -ignores CF past cutoff date -conventional projects ONLY
disadvantage of PI
-ignores scale -may lead to incorrect decisions in comparisons of mutually exclusive investments (tells the manager the value creates per dollar but doesn't account for how many dollars the projects require)
disadvantages of discounted payback
-not simpler than just finding NPV, complicated -requires arbitrary cutoff point -may reject positive NPV investments -biased against LT projects -ignores CFs past cutoff date -conventional projects only
advantages of IRR
-simpler to understand (rate vs. dollar amount) -don't need an appropriate discount rate to estimate (and if the IRR is high enough, you may not need to estimate a required return (VCs often do this)) -closely related to NPV
pros to the payback rule
-used with minor decisions (you can easily see if the benefits outweigh the losses) -simple -biased to liquidity which is important for small businesses (use when you're concerned about liquidity) -adjusts for riskiness of later cash flows (by ignoring them)
NPV/IRR/PI are
3 interpretations of the same equation
An advantage of discounted payback is that it does not reject positive NPV investments.
False
If a project has multiple IRRs, you implement the IRR rule by comparing the highest IRR to the required return. That's the value maximizing approach.
False
The profitability index measures the the value created in a project given the dollars invested, adjusting for the time value of money.
False
When faced with mutually exclusive projects, the profitability index is the "go to" rule.
False
where do you look to decide between multiple IRRs?
NPV profile note that when you pick different rates, you're emphasizing different points on a timeline. lower rates make later money more important
which rules account for the risk of the CFs?
NPV, IRR, PI, Payback (kind of), Discounted Payback (kind of)
PI calculation
PV of future CFs/Initial investment (this version is only applicable to conventional CFs but you can use if for nonconventional CFs too) PV inflows/PV outflows (don't need minus sign for outflows because it will always be positive) 1 + (NPV/Cost)
as required return increases, PV of inflows/outflows...
PV of inflows decreases and PV of outflows stays the same chance you're gonna reject increases
NPV rule
accept if (+) if the PV of cash inflows > PV of cash outflows, accept the project
IRR rule
accept if IRR > required return on our assets
discounted payback rule
accept if discounted payback period is less than some preset limit
choosing between projects with PI
always go PI to lowest and assume you can use fractional projects (use all your money up!)
payback period
amount of time required for an investment to generate cash flows sufficient to recover its initial cost
NPV logic
an investment is worth undertaking if it creates value for its owners since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal
what is one thing all of the rules have in common
firm must begin capital budgeting process by estimating a project's CFs
PI of 1.1 implies
for every $1 of investment, we create an additional 0.10 in value
pre vs. post mortem
good firms do a post-mortem- comparing actual versus expected better firms do a pre-moretum- what assumptions are we missing? what disasters could happen?
NPV profile
graph that shows relationship between an investment's NPV (y axis) and various discount rates (x-axis) curve crosses x-axis at IRR
IRR and it's focus on early/later money
high rate focuses attention on early money low rate focuses attention on later money
as time increases, the estimation error of payback
increases
payback period for an annuity
initial cost/annual CF
payback rule
investment is acceptable if payback period is less than some prespecified number of years "break even" measure in an accounting (nominal) sense, not in an economic sense
profitability index definition
is a ratio also called benefit-cost ratio measures value created per dollar invested in a project, adjusting for TVM will be >1 for positive NPV investments and <1 for negative NPV investments
overall, why don't we just use NPV?
it's an estimate, and the others are clues to whether NPV is reliable
effects of payback rule shortcomings
leads people to take investments worth less than they already cost and leads people to reject profitable long-term investments
discounted payback
length of time until the sum of the DCFs = initial investment payback rule + adjustment for TVM "break even" measure in an economic (PV) sense
when they cross, where do NPV/IRR agree disagree
they disagree to left of crossover point and agree to right
how does the NPV/IRR account for risk?
through the required return rate
For a conventional project, NPV is the difference between the project's cost and the present value of its expected future cash flows.
true
IRR and Nonconventional CF
when the CFs change sign more than once, there could as many IRRs as there are sign changes
when should you use discounted payback?
when you're concerned about risk and have a high OC
