FINC 300 - CHAPTER 9 Capital Budgeting: Net Present Value and Other Investment Criteria

____________ budgeting is the decision-making process for accepting and rejecting projects.

Capital

Non-conventional Cash flows

Cash flows change sign more than once - Means you have more than one IRR

Reinvestment Approach

Compound all cash flows (negative and positive) except the initial investment to the end of the project's life

Net Present Value (NPV)

Difference between investment's market value and its costs

Discounting Approach

Discount all negative cash flows to present at required return and add to initial cost

Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period?

Discounted payback period

What are the THREE approaches to modifying cash flows?

Discounting Approach Reinvestment Approach Combination Approach

The profitability index is calculated by dividing the PV of the _________ cash flows by the initial investment.

Future

IRR Rule

Investment is acceptable if IRR EXCEEDS the required return

NPV Rule

Investment is accepted if NPV is positive and rejected if negative

If a project has multiple internal rates of return, which of the following methods should be used?

NPV & MIRR

Advantages of AAR

Needed information is usually available. Is easy to compute.

Which of the following are advantage(s) of AAR?

Needed information is usually available. Is easy to compute.

Combination Approach

Negative cash flows are discounted back to the present, and positive cash flows are compounded to the end of the project

__________ is a measure of how much value is created or added today by undertaking an investment.

Net Present Value

Examples of capital budgeting include:

New machinery Replacement machinery New plants New products Research & development projects

NPV and IRR rules always lead to identical decisions except under WHICH two conditions?

Non-conventional and mutually exclusive cash flows

This capital budgeting method allows lower management to make smaller, everyday financial decisions effectively.

Payback method

Probability Index

Present value of the future cash flows DIVIDED by the initial investment

Which of the following is an example of an opportunity cost?

Rental income likely to be lost by using a vacant building for an upcoming project

Internal Rate of Return (IRR)

Required return that results in a ZERO NPV when it is used as the discounted rate

Using the payback period rule will bias toward accepting which type of investment?

Short-term investment

In which of the following scenarios would IRR always recommend the wrong decision?

Starting cash flow: 1000 Ending cash flow: -2000

Mutually exclusive cash flows

Taking one investments prevents taking another

What are the advantages of the payback period method for management?

The payback period method is ideal for short projects. It allows lower level managers to make small decisions effectively. The payback period method is easy to use.

True or False: Payback period does not include time value of money. Discounted payback includes time value of money.

True

True or false: Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified number of years.

True

True or false: The crossover rate is the rate at which the NPVs of two projects are equal.

True By definition, the crossover rate occurs when the NPVs of two mutually exclusive projects are equal.

True or false: Some projects, such as mines, have cash outflows followed by cash inflows, which are then followed by cash outflows, giving the project multiple rates of return.

True Whenever subsequent cash flows are both negative and positive, multiple internal rates of return will occur.

Multiple rates of return

With nonconventional cash flows, there is a possibility that more than one discount rate will make the NPV of an investment zero.

Modified Internal Rate of Return (MIRR)

a capital budgeting method that converts a project's cash flows using a more consistent reinvestment rate prior to applying the IRR decision rule

When is the average accounting return acceptable?

a project is acceptable if its average accounting return exceeds a target average accounting return.

The internal rate of return is a function of ____.

a project's cash flows

The PI rule for an independent project is to ______ the project if the PI is greater than 1.

accept

A project should be __________ if its NPV is greater than zero.

accepted

NPV ____ cash flows properly

discounts

The three attributes of NPV are that it:

discounts the cash flows properly. uses cash flows. uses all the cash flows of a project.

The AAR _________ (does/doesn't) incorporate time value of money.

does

An independent project _______ (does/doesn't) rely on the acceptance or rejection of another project.

doesn't

A situation in which taking one investment prevents the taking of another is called a mutually _______ investment decision.

exclusive

The basic NPV investment rule is:

if the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference. accept a project if the NPV is greater than zero. reject a project if its NPV is less than zero.

The IRR can lead to the wrong decision when cash ________ (inflows/outflows) occur before cash _________ (inflows/outflows).

inflows, outflows

The payback period method allows lower management to make _________ (smaller/larger), everyday financial decisions effectively.

larger

By ignoring time value, the payback period rule may incorrectly accept projects with a _______ (positive/negative) NPV.

negative

By ignoring time value, the payback period rule may incorrectly accept projects with a _______ NPV.

negative

The ____________ method differs from NPV because it evaluates a project by determining the time needed to recoup the initial investment.

payback

For a project with conventional cash flows, the NPV is ______ if the required return is less than the IRR, and it is ______ if the required return is greater than the IRR.

positive, negative

In capital budgeting, the net ______ determines the value of a project to the company.

present value

The IRR rule can lead to bad decisions when _____ or _____.

projects are mutually exclusive cash flows are not conventional

According to the basic IRR rule, we should _____.

reject a project if the IRR is less than the required return

Internal rate of return (IRR) must be compared to the ________ in order to determine the acceptability of a project.

required return

The payback period method allows lower management to make ___________, everyday financial decisions effectively.

smaller

Capital Budgeting

the process of planning and managing a firm's long-term investments

Crossover rate

the rate at which the NPVs of two projects are equal

The IRR is the discount rate that makes the NPV of a project equal to ______.

zero

The spreadsheet function for calculating net present value is ____.

=NPV()