Finance 325 Chapter 9

9.1a- What is the net present value rule?

An investment should be accepted if the NPV is positive and rejected if it is negative

9.6a- What does the profitability index measure?

The PV of an investment's future cash flows / its initial cost Also called the benefit-cost ratio Measures- "bang for buck" the value created per dollar invested.

9.3a-In words, what is the discounted payback period? Why do we say it is, in a sense, a financial or economic break-even measure?

Discounted payback period is the length of time required for an investment's discounted cash flows to equal its initial cost. Ordinary payback is the imte it takes to break even in an account sense. Because it includes the time value of money, the discounted payback is the time it takes to break even in an economic or financial sense.

9.1b- If we say an investment has an NPV of $1000, what exactly do we mean?

The difference between an investment's market value and its cost is $1000

9.2a-In words, what is the pay back period? the payback period rule?

The payback period is the amount of time required for an investment to generate cash flows sufficient to recover its initial cost Payback Period Rule is an investment is acceptable if its calculated payback period is less than some pre-specified number of years.

9.4a-What is an average accounting rate of return (AAR)?

average net income / average book value

9.4b- What are the weaknesses of the AAR rule?

The rule is: a project is acceptable if its average accounting return exceeds a target average accounting return 1. not a true rate of return; time value of money is ignored 2. Uses an arbitrary benchmark cutoff rate 3. Based on accounting (book) values, not cash flows and market values

9.3b- What advantage(s) does the discounted payback have over the ordinary payback?

1. Includes time value of money 2. Easy to understand 3. Does not accept negative estimated NPV investments 4. Biased toward liquidity

9.5a-Under what circumstances will the IRR and NPV rules lead to the same accept-reject decisions? When might they conflict?

1. the project's cash flows must be conventional, meaning that the first cash flow (the initial investment) is negative and all the rest are positive-- usually met 2. The project must be independent, meaning that the decision to accept or reject this project does not affect the decision to accept or reject any other ......