FIN chapter 9

IRR Advantages:

Considers all of the cash flows in the computation • Uses the time value of money • If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task • Usually provides a similar answer to the NPV computation

Net Present Value Advantages

Considers all of the cash flows in the computation • Uses the time value of money • Provides the answer in dollar terms, which is easy to understand • Usually provides a similar answer to the IRR computation

Internal Rate of Return (IRR)

It is the discount rate (or required return) that will bring all of the cash flows into present value time and total the exact value of the cost of the project. (it is the return that will yield a NPV = $0)

Why is payback often used as the sole method of analyzing a proposed small project?

It is the only method where the benefits of the analysis outweigh the costs of the analysis

Modified Internal Rate of Return (MIRR)-

MIRR differentiates itself from IRR in that the reinvestment rate for the cash flows is determined by the evaluator. It is the interest rate that compares the future value of the cash flows with the cost of the project.

Since our goal is to increase owner wealth....

NPV is a direct measure of how well this project will meet our goal, as measured in dollar terms.

Which on of the following methods determines the amount of the change a proposed project will have on the value of a firm?

Net present value

Formula for PI

PI = PV CF/ IC

Formula for IRR

Put in calculator

Computation of MIRR

Step 1: Take the Cash flows to the end of the project and add them up; this is labeled the "terminal value". Step 2: Find the rate of return that equates the cost with the terminal value for the life of the project. This is the MIRR.

Average Accounting Return (AAR)

The AAR is a measure of the average accounting profit compared to some measure of average accounting value of a project. The AAR is then compared to a required return by the company.

Average Accounting Return Advantages

Easy to calculate Needed information will usually be available

Payback Advantages

Easy to understand and compute (you just subtract!) Adjusts for uncertainty of later cash flows Biased toward liquidity

Discounted Payback Period-

How long does it take to get the initial cost back after you bring all of the cash flows to the present value? Computation: 1. Estimate the present value of the cash flows 2. Subtract the future cash flows from the initial cost until the initial investment has been recovered Example: Year 1: 165,000 - 56,357 = 108,643; continue Year 2: 108,643 - 56,441 = 52,202; continue Year 3: 52,202 - 64,829 = -12,627; finished

Payback Period

How long does it take to get the initial cost back in a nominal sense? Computation: o Estimate the cash flows o Subtract the future cash flows from the initial cost until the initial investment has been recovered

Profitability Index

The PI measures the benefit per unit cost of a project, based on the time value of money. It is very useful in situations where you have multiple projects of hugely different costs and/or limited capital (capital rationing).

Net Present Value-

The difference between the market value of a project and its cost

Which one of the following increases the net present value of a project?

an increase in the aftertax salvage value of the fixed assets

The internal rate of return is defined as the:

discount rate which causes the net present value of a project to equal zero

Which one of the following methods of project analysis is defined as computing the value of a project based upon the present value of the project's anticipated cash flows?

discounted cash flow valuation

The length of time a firm must wait to recoup, in present value terms, the money it has invested in a project is referred to as the:

discounted payback period

The task...

is if we should purchase the project

The benefit of MIRR over IRR.....

is that we can produce a single number with specific rates for borrowing and reinvestment.

Net present value:

is the best method of analyzing mutually exclusive projects.

The goal with projects....

is to determine if we will exceed our cost with the cash flows identified.

positive NPV.....

means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.

If a firm accepts Project A it will not be feasible to also accept Project B because both projects would require the simultaneous and exclusive use of the same piece of machinery. These projects are considered to be:

mutually exclusive

A project has an initial cost of $27,400 and a market value of $32,600. What is the difference between these two values called?

net present value

The present value of an investment's future cash flows divided by the initial cost of the investment is called the:

profitability index

If a project has a net present value equal to zero, then:

the project earns a return exactly equal to the discount rate

Profitability Index Advantages

• Closely related to NPV, generally leading to identical decisions • Easy to understand and communicate • May be useful when available investment funds are limited

Payback Disadvantages

• Ignores the time value of money • Requires an arbitrary cutoff point • Ignores cash flows beyond the cutoff date • Biased against long-term projects, such as research and development, and new projects

Discounted Payback Advantages

• Includes time value of money • Easy to understand • Biased towards liquidity

Profitability Index Disadvantages:

• May lead to incorrect decisions in comparisons of mutually exclusive investments

Average Accounting Return Disadvantages

• Not a true rate of return; time value of money is ignored • Uses an arbitrary benchmark cutoff rate • Based on accounting net income and book values, not cash flows and market values

Discounted Payback Disadvantages

• Requires an arbitrary cutoff point • Ignores cash flows beyond the cutoff point • Biased against long-term projects, such as R&D and new products

Net Present Value Disadvantages

• Requires the use of the time value of money, thus a bit more difficult to compute • Projects that differ by orders of magnitude in cost are not obvious in the NPV final figure

IRR Disadvantages:

• Uses the firm's required rate of return for comparison purposes. • Unusually high numbers can often occur when a significant amount of the project's cash flows occur early in the life of the project.

Formula for AAR

Average NI/ Average BV

Rossiter Restaurants is analyzing a project that requires $180,000 of fixed assets. When the project ends, those assets are expected to have an aftertax salvage value of $45,000. How is the $45,000 salvage value handled when computing the net present value of the project?

cash inflow in the final year of the project

Which one of the following will decrease the net present value of a project?

increasing the project's initial cost at time zero