FINC 3610 Chapter 9
Rossiter Restaurants is analyzing a project that requires $180,000 of fixed assets. When the project ends, those assets are expected to have an after-tax 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 aftertax salvage value is included in the present value of cash inflows and is considered in the cash inflows in the final year; the project is completed when the fixed assets are sold
Advantages of Profitability Index
Closely related to NPV, generally leading to identical decisions Easy to understand and communicate May be useful when available investment funds are limited
which of the following would increase the NPV of a project? A. an increase in the required rate of return B. an increase in the initial capital requirement C. a deferment of some cash inflows until a later year D. an increase in the aftertax salvage value of the fixed assets E. a reduction in the final cash inflow
D. an increase in the aftertax salvage value of the fixed assets
Which of the following will decrease the net present value of a project? A. increasing the value of each of the project's discounted cash inflows B. moving each of the cash inflows back to a later time period C. decreasing the required discount rate D. increasing the project's initial cost at time zero E. increasing the amount of the final cash inflow
D. increasing the projects initial cost at time zero.
The final decision on which one of two mutually exclusive projects to accept ultimately depends upon which one of the following? A. initial cost of each project B. timing of the cash inflows C. total cash inflows of each project D. required rate of return E. length of each project's life
D. required rate of return
22. A project has a required payback period of three years. Which one of the following statements is correct concerning the payback analysis of this project? A. The cash flows in each of the three years must exceed one-third of the project's initial cost if the project is to be accepted. B. The cash flow in year three is ignored. C. The project's cash flow in year three is discounted by a factor of (1 + R)^3 . D. The cash flow in year two is valued just as highly as the cash flow in year one. E. The project is acceptable whenever the payback period exceeds three years.
D. the cash flow in year two if valued just as highly as the cash flow in year one. the payback period rule assumes that cash flows are received uniformly through the years.
Which one of the following methods of analysis provides the best information on the cost-benefit aspects of a project? A. net present value B. payback C. internal rate of return D. average accounting return E. profitability index
E. Profitability Index
Advantages of Average Accounting Return
Easy to calculate Needed information will usually be available
Disadvantages of Discounted Payback Period
may reject positive NPV investments requires an arbitrary cutoff point ignores cash flows beyond the cutoff date biased against long-term projects (ex: research and development; new projects)
Disadvantages of IRR
may result in multiple answers with nonconventional cash flows may lead to incorrect decisions in comparisons of mutually exclusive investments
There are two distinct discount rates at which a particular project will have zero NPV. In this situation, the project is said to have...
multiple rates of return
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
Advantages of MIRR over IRR
no longer possible to get multiple answers, and is its closely related to NPV
What is the Profitability Index Rule?
only accept projects with a PI greater than 1, and invest in projects with the greatest PI first.
the length of time a firms must wait to recoup the money is has invested in a project
payback period
The present value of an investment's future cash flows divided by the initial cost of the investment is called the:
profitability index
Applying the discounted payback decision rule to all projects may cause:
some positive NPV projects to be rejected.
what does the payback period rule assume?
that cash flows are received uniformly throughout the year.
what does the NPV rule assume?
that cash flows are reinvested at the discount rate
what is the payback period?
the amount of time required for an investment to generate cash flows sufficient to recover its initial cost
what is net present value?
the difference between an investment's market value and its cost
What is the internal rate of return (IRR)?
the discount rate that makes the NPV of an investment equal to zero closely related to NPV; most important alternative
what are the 3 methods of MIRR?
the discounting approach the reinvestment approach the combination approach
what is the discounted payback period?
the length of time required for an investment's DISCOUNTED cash flows to equal its initial cost
multiple rates of return problem
the possibility of more than one discount rate making the NPV of an investment zero problem usually happens when using a computer to find the IRR because it will only report one percentage.
what is discounted cash flow (DCF) valuation?
the process of valuing an investment by discounting its future cash flows
If a project has a net present value equal to zero, then:
the project earns a return exactly equal to the discount rate
A project has a net present value of zero. Which one of the following best describes this project?
the project's cash inflows equal its cash outflows in present value terms
what is the MIRR discounting approach?
to discount all the negative cash flows to present value and add them to the initial cost Then calculate the IRR leads to only one IRR
what is the MIRR reinvestment approach?
we compound all cash flows (positive and negative) except the first to the end of the projects life calculate IRR we "reinvest" cash flows and don't take them out until projects end
What is the modified internal rate of return (MIRR)?
a calculation of IRR on modified cash flows.
what is the combination approach?
a combination of the discounting and reinvestment approach. discount all cash outflows to the present (time 0) and compound all cash inflows to the end of the project. then calculate the IRR that makes them equal to each other
what is a net present value profile?
a graphical representation of the relationship between an investment's NPVs and various discount rates
What is the average accounting return rule?
a project is acceptable if its average accounting return exceeds a target average accounting return
what are mutually exclusive investment decisions?
a situation where taking one investment prevents the taking of another
When the present value of the cash inflows exceeds the initial cost of a project, then the project should be:
accepted because the profitability index is greater than 1
what is the payback period rule?
an investment is acceptable if its calculated payback period is less than some respecified number of years.
What is the IRR rule?
an investment is acceptable if the IRR exceeds the required return, otherwise reject it
What is the MIRR rule?
an investment is acceptable if the MIRR exceeds the required rate of return. it should be rejected otherwise
What is the average accounting return (AAR)?
an investment's average net income divided by its average book value
a project's average net income divided by its average book value is referred to as the project's...
average accounting rate of return
Mutually exclusive projects are best defined as competing projects which:
both require the total use of the same limited resource
disadvantages of payback period
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
Advantages of Discounted Payback Period
Includes time value of money Easy to understand Does not accept negative estimated NPV investments when all future cash flows are positive Biased towards liquidity
Disadvantages of Profitability Index
May lead to incorrect decisions in comparisons of mutually exclusive investments
You are viewing a graph that plots the NPVs of a project to various discount rates that could be applied to the project's cash flows. What is the name of this graph?
NPV Profile
Disadvantages of NPV
Needs appropriate discount rate relatively more difficult to communicate to others
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 NPV is the difference b/t the present value of cash inflows and outflows
Disadvantages of Average Accounting Return
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
How do you find the payback period?
calculate the number of years it will take for the future cash flows to match the initial cash flows
Advantages of IRR
closely related to NPV, often leading to identical decisions easy to understand and communicate
How to calculate IRR (EX)
cost of project = $100 future cash inflow = $100 IRR = r NPV = 0 0 = -$100 + [110/(1+r)] 100 = 110/(1+r) 1+r = $110/100 1+r = 1.1 r=.1 or 10%
what method 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 firms must wait to recoup the money is has invested in a project, IN PRESENT VALUE TERMS
discounted payback period
What questions do we need to ask ourselves when evaluating capital budgeting decision rules?
does the decision rule adjust for time value of money does the decision rule adjust for risk does the decision rule provide information on whether we are creating value for the firm
Advantages of Payback Period
easy to understand adjusts for uncertainty of later cash flows biased toward liquidity
How do you calculate the net present value of a project?
estimate the future cash flows calculate the present value of those cash flows then subtract the initial cost of the project
Samuelson Electronics has a required payback period of 3 years for all of its projects. Currently, the firm is analyzing two independent projects. Project A has an expected payback period of 2.8 years and a net present value of $6,800. Project B has an expected payback period of 3.1 years with a net present value of $28,400. Which projects should be accepted based on the payback decision rule?
Project A because project B's payback period exceeds the required period so it cannot be accepted
calculating AAR
(average net income)/(average book value)
how to calculate Profitability Index
(present value of future cash flows)/(the initial cost)
Advantages of NPV
- considers all of the cash flows in the computation - adjusts for the time value of money - provides the answer in dollar terms, which is easy to understand
what is the discounted payback rule?
An investment is acceptable if it is discounted payback is less than some pre-specified number of years
what is the net present value rule?
An investment should be accepted if the net present value is positive and rejected if it is negative.
what is the profitability index?
The present value of an investment's future cash flows divided by its initial cost. Also called the benefit-cost ratio.
True of False: the IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate.
True