BF Ch. 9

NPV profile

a graph of a project's NPV over a range of discount rates

discounted payback period

Calculates the time it takes to get back invested capital in present value terms; Alleviates the problem of the regular payback period by incorporating The time value of money; Doesn't take into account payback after investment is recouped -discount each year's cash flow

The present value of the benefits and costs needed to calculate PI is the same information one finds when computing the NPV.

True

One of the underlying assumptions of the IRR model is that all cash inflows can be reinvested at the individual project's internal rate of return (IRR) over the remaining life of the project.

True

what are the shortcomings of the payback period model?

-biased towards projects with higher cash inflows for earlier years -fails to account for the time value of money

3 observations we can make about the capital budgeting decision

1. capital budgeting decision is typically a go or no-go decision on a product, service, or activity 2. a capital budgeting decision will require sound estimates of the time and amount of appropriate cash flow for the proposal 3. the capital budgeting model has a predetermined accept or reject criterion

hurdle rate

Minimum acceptable rate of return (set by management) for an investment.

profitability index

PI = NPV + cost / cost if PI > 1, accept the project; if PI < 1, reject the project

equivalent annual annuity

The level annual cash flow that has the same present value as the cash flows of a project. Used to evaluate alternative projects with different lives.

IRR

defined as the discount rate that produces a zero NPV or the specific discount rate at which the present value of the cost (the investment or cash outflows) equals the present value of the future benefits (cash inflows). The IRR rule prescribes that we should accept those investments in which the internal rate of return exceeds the required rate of return.

The most popular alternative to NPV for capital budgeting decisions is the ________ method.

internal rate of return

capital budgeting

long term decisions/investments

If we consider the terminal value of the cash inflow (their future values based on the company's cost of capital) we can then begin to find a ________ that gives the answer in terms of returns generally consistent with the dollar amounts of NPV.

modified internal rate of return (MIRR)

The ________ method is the one method that trumps all other capital budgeting methods.

net present value

payback period

the amount of time required for an investment to generate cash flows sufficient to recover its initial cost

crossover rate

the discount rate at which both projects have the same NPV

net present value

the present value of current and future benefits minus the present value of current and future costs

modified internal rate of return

underlying assumption that all cash flows are reinvested at the firm's cost of capital