Finance chapter 10
Net Present Value (NPV)
-goal of maximizing shareholder wealth -compares the present value of expected benefits and cash flows from a project to the present value of the expected costs; if the benefits are larger, the project is feasible
ARR Flaws
-is not a true rate of return; it is generated from the income statement and balance sheet -It ignores the time value of money -There is no economic rationale that makes it consistent with the goal of maximizing shareholder wealth
Which of the following cash flow patterns is NOT an unconventional cash flow pattern?
A negative initial cash flow is followed by positive future cash flows.
Which of the following rates should be used to calculate a project's net present value?
Cost of capital
The goal of the capital budgeting decisions is to select capital projects that will decrease the value of the firm. (True/False)
False
The net present value technique is an approach that goes against the goal of shareholder wealth maximization. (True/False)
False
The payback method is consistent with the goal of shareholder wealth maximization. (True/False)
False
When mutually exclusive projects are considered, both NPV and IRR will always produce the same acceptance decision. (True/False)
False
When two projects are independent, accepting one project implicitly eliminates the other. (True/False)
False
When two projects have cash flows that are tied to each other, the projects may be classified as independent. (True/False)
False
The NPV and IRR methods will always agree when you are evaluating _____ projects and the project's cash flows are _____.
independent; conventional
Cost of Capital
rate of return that a project must earn to be accepted by management
Capital budgeting
techniques help management systematically analyze potential opportunities in order to decide which are worth undertaking
The internal rate of return is
discount rate that makes the NPV equal to zero.
A weakness of the accounting rate of return technique is, it:
does not distinguish between revenue and cash flows.
Capital rationing
firm with limited funds chooses the best projects to undertake
Basic Capital Budgeting
-Capital rationing -Capital Asset -Cost of Capital
What method should be used when dealing with unconventional cash flows, IRR or NPV?
NPV Because,With unconventional cash flows, the IRR technique may provide more than one rate of return. This makes the calculation unreliable and it should not be used to determine whether a project should be accepted or rejected
Contingent projects
Projects for which the decision to accept one project depends on acceptance of another project
Mutually exclusive projects
Projects for which the decision to accept one project is simultaneously a decision to reject another project
Which of the following statements about IRR is NOT true?
The IRR is the discount rate that makes the NPV greater than zero.
Capital rationing implies that
a firm has constraint to fund all of the available projects.
Practical difficulties in valuing real assets
-Cash flow estimates must be prepared in-house and are not as readily available as those for financial assets with legal contracts -Estimating required-rates-of-return for real assets is more difficult than estimating required return for financial assets because no market data is available
disadvantage of the payback method?
-It is inconsistent with the goal of maximizing shareholder wealth. -It ignores cash flows beyond the payback period. -It ignores the time value of money.
Payback Period
-The Payback Period is the amount of time it takes for the sum of the net cash flows from a project to equal the project's initial investment *Projects with shorter payback periods are more desirable
Valuation of Real Assets
1.Estimate future cash flows 2.Estimate cost of capital/required-rate-of return 3.Calculate present value of future cash flows
Advantages of NPV 3
1.uses discounted cash flow valuation technique to adjust for time value of money. 2.Provides direct (dollar) measure of how much a capital project will increase the value of the firm. 3.Consistent with the goal of maximizing stockholder value.
Disadvantages of IRR
1.with non-conventional cash flows, IRR approach can yield no usable answer or multiple answers. 2.A lower IRR can be better if a cash inflow is followed by cash outflows 3.With mutually exclusive projects, IRR leadto incorrect investment descisions 4.IRR calculation assumes cash flows are reinvested at the IRR.
Disadvantage of NPV
Can be difficult to understand without an accounting and finance backround.
Negatives about Payback rule
There is no economic rationale that makes the payback method consistent with shareholder wealth maximization -It ignores the time value of money -Does not account for differences in the overall risk of projects -Cash flows occurring after the payback period are not considered
The IRR and NPV methods always rank projects in the same order. (True/False)
False *The IRR and NPV methods can give conflicting results
The IRR is the discount rate that makes the NPV positive (True/False)
False *The IRR is the discount rate that makes the NPV equal to zero.
The cost of capital for a project is its return on equity. (True/False)
False *The cost of capital is the rate of return that a capital project must earn to be accepted by management.
Unconventional cash flow patterns could lead to conflicting decisions by NPV and IRR. (True/False)
True
When evaluating two projects that require different outlays, the IRR does not recognize the difference in the size of the investments. (True/False)
True
When two projects are mutually exclusive, accepting one project implicitly eliminates the other. (True/False)
True
If a project's IRR exceeds its _____, the project should be _____.
cost of capital; accepted
Advantages of IRR Method
1.Intutive and easy to understand 2.Based on discounted cash flow technique
Advantage of the payback method
Both the technique is simple for managers to compute and interpret and it is a good measure of liquidity risk.
The decision criterion for the accounting rate of return is consistent with the goal of shareholder wealth maximization. (True/False)
False
Which of the following capital budgeting techniques, is the most appropriate one for evaluating projects?
Net present value
Independent Projects
Projects for which the decision to accept or reject is not influenced by decisions about other projects being considered by the firm
Profitability Index (PI)
The PI provides a measure of the value of project generates for each dollar invested in that project
The IRR and NPV decisions are consistent with each other when a project's cash flows follow a conventional pattern. (True/False)
True
The NPV method determines how much the present value of cash inflows exceeds the present value of costs. (True/False)
True
The accounting rate of return is not a true return because it simply utilizes some average figures from a firm's balance sheet and income statement. (True/False)
True
The discounted payback period calculation calls for the future cash flows to be discounted by a firm's cost of capital. (True/False)
True
key disadvantage of the IRR method?
With mutually exclusive projects, the IRR method can lead to incorrect investment decisions.
When evaluating capital projects, the decisions using the NPV method and the IRR method will agree if
both the projects are independent and the cash flow pattern is conventional.
Two projects are considered to be mutually exclusive if
both selecting one would automatically eliminate accepting the other and the projects perform the same function.
What is true of an independent project?
cash flows are unrelated.
One of the main reasons why the discounted payback period is not widely used by managers is that:
it ignores all cash flows that occur after the arbitrary cutoff period
Capital investments
large cash outlays, long-term commitments, not easily reversed, and primary factors in a firm's long-run performance
Capital Asset
long-term assets
The cost of capital is
minimum return that a capital project must earn to be accepted