FINC 315 ch 9

[IRR] what is the relationship between IRR and NPV? are there any situations in which you might prefer one method over the other? explain.

IRR is the interest rate that causes NPV of a series of cash flows to be 0. NPV is preferred in all situations to IRR for stand-alone projects NPV and IRR are interchangeable

[profitability index] what is the relationship between the profitability index and NPV? are there any situations in which you might prefer one method over the other? explain.

PI = (NPV + cost)/cost =1 + (NPV/cost). if a firm has a lot of projects with positive NPV and is subject to capital rationing, PI may provide a good ranking of the projects

[discounted payback] describe how the discounted payback period is calculated, and describe the information this measure provides about a sequence of cash flow. what is the discounted payback criterion decision rule?

calculation- same as regular payback, with the exception that each cash flow in the series is first converted to its present value provides a measure of financial/economic break-even because of this discounting (length of time required for an investment's discounted cash flows to equal its cost) decision rule: accept an investment if its discounted payback is less than some pre specified number of years

[IRR] despite its shortcomings in some situations, why do most financial managers use IRR along with NPV when evaluating projects? can you think of a situation in which IRR might be more appropriate measure to use than NPV? explain.

it is easier for financial managers to rate performance in relative terms, 12% (IRR), than in absolute terms, $46,000 (NPV), IRR would be preferred in a situation where the discount rate was unknown, IRR would provide more information about the project than would NPV

[international investment projects] in oct 2010, automobile manufacturer BMW announced plans to invest $750 million to increase production at its SC plant by 50%. BMW apparently felt that it would be better able to compete and create value with US based facilities. other companies such as Fuji Film and Swiss chemical company Lonza have reached similar conclusions and taken similar actions. What are some of the reasons that foreign manufacturers of products as diverse as automobiles, film, and chemicals might arrive at this same conclusion?

manufacturing in the US places the finished product much closer to the point of sale (savings in transportation costs) goods spend less time in transit (reduces inventories) higher portion of costs are paid in dollars. since sales are in dollars, the net effect is to immunize profits to a large extent against fluctuations in exchange rates

[average accounting return] what are the problems associated with using the AAR to evaluate a project's cash flows? what underlying feature of AAR is most troubling to you from a financial perspective? does the AAR have any redeeming qualities?

not a true rate of return; time value of money is ignored uses an arbitrary benchmark cutoff rate based on accounting (book) values, not cash flows and market values most troubling: the reliance on accounting numbers rather than relevant market data and the exclusion of time value of money easy to calculate, needed information will usually be available

[payback period and net present value] if a project with conventional cash flows has a payback period less than the project's life, can you definitively state the algebraic sign of the NPV? why or why not? if you know that the discounted payback period is less than the project's life, what can you say about the NPV? explain

payback period < project's life means that the NPV is positive for a zero discount rate, but nothing more definitive can be said. for discount rates greater than zero, the payback period will still be less than the project's life, but the NPV may be positive, zero, or negative, depending on whether the discount rate is less than, equal to, or greater than the IRR. the discounted payback includes the effect of the relevant discount rate. if a project's discounted payback period is less than the project's life, it must be the case that NPV is positive

[payback period] describe how the payback period is calculated, and describe the information this measure provides about a sequence of cash flows. what is the payback criterion decision rule?

payback period- the accounting break-even point of a series of cash flows. computation: estimate the cash flows. subtract the future cash flows form the initial cost until the initial investment has been recovered decision rule- accept an investment if its calculated payback period is less than some pre specified number of years

[payback and IRR] a project has perpetual cash flows of C per period, a cost of I, and a required rate of R. what is the relationship between the project's payback and its IRR? what implications does your answer have for long-lived projects with relatively constant cash flows?

payback ratio= I/C IRR=C/1 IRR is the reciprocal of the payback ratio long lived projects: the sooner the project pays back, the greater is the IRR

NPV pros and cons

pros: considers all the cash flows in the computation uses the time value of money provides the answer is dollar terms, which is easy to understand usually provides a similar answer to the IRR computation cons: requires the use of the time value of money, more difficult to compute projects that differ by orders of magnitude in cost are not obvious in the NPV final figure

discounted payback pros and cons

pros: includes time value of money easy to understand biased towards liquidity cons: requires arbitrary cutoff point ignores cash flows beyond the cutoff point biased against long-term projects, such as R&D and new products

[discounted payback] what are the problems associated with using the discounted payback period to evaluate cash flows?

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

[average accounting return] describe how the average accounting return is usually calculated, and describe the information this measure provides about a sequence of cash flows. what is the AAR criterion decision rule?

average measure of the accounting performance of a project over time calculation: average net income divided by its average book value decision rule: accept a project if its AAR exceeds a target AAR

[net present value] describe how NPV is calculated, and describe the information this measure provides about a sequence of cash flows. what is the NPV criterion decision rule?

calculate: the difference between an investment's market value and its cost measures: how much value is created or added today by undertaking an investment decision rule: accepted if the NPV is positive rejected if the NPV is negative

[IRR] descrive how the IRR is calculated, and describe the information this measure provides about a sequence of cash flows. what is the IRR criterion decision rule?

calculated: discount rate that causes the NPV of a series of cash flows to be exactly 0 measure: a financial break-even rate of return (at IRR the net value of the project is 0 decision rule: accept projects if the IRR exceeds the required return. reject everything else

[modified IRR] one of the less flattering interpretations of the acronym MIRR is "meaningless internal rate of return". why do you think this term is applied to MIRR?

calculated: finding the present value of all cash outflows, the future value of all cash inflows to the end of the project, ad then calculating the IRR of the two cash flows

[profitability index] describe how the profitability index is calculated, and describe the information this measure provides about a sequence of cash flows. what is the profitability index decision rule?

calculated: the present value of an investment's future cash flows divided by its initial cost measure: the relative profitability of a project decision rule: accept projects with a PI greater than one, reject projects with a PI less than one

[payback period] what are the advantages of using the payback period to evaluate cash flows? are there any circumstances under which using payback might be appropriate? explain.

easy to understand adjusts for uncertainty of later cash flows biased towards liquidity appropriate: maintenance projects- detailed analysis of other methods is not needed short-term projects

[payback period] what are the problems associated with using the payback period to evaluate cash flows?

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

[discounted payback] what conceptual advantage does the discounted payback method have over the regular payback method? can the discounted payback ever be longer that the regular payback? explain.

includes time value of money easy to understand does not accept negative estimated NPV investments biased toward liquidity for conventional cash flows and strictly positive discount rates, the discounted payback will always be greater than the regular payback period

[net present value] why is NPV considered a superior method of evaluating the cash flows from a project? suppose the NPV for a project's cash flows is computed to be $2,500. what does this number represent with respect to the firm's shareholders?

it has no serious flaws. NPV unambiguously ranks mutually exclusive projects, and can differentiate between projects of different scale and time horizon. only drawback is that it relies on cash flow and discount rate values that are often estimates and not certain. NPV=2,500 implies that the total shareholder wealth of the firm will increase by 2,500 if the project is accepted

PI pros and cons

pros: closely related to NPV, generally leading to identical decisions easy to understand and communicate may be useful when available investment funds are limited cons: may lead to incorrect decisions in comparisons of mutually exclusive investments

IRR pros and cons

pros: closely related to NPV, often leading to identical decisions easy to understand and communicate cons: may result in multiple answers or not deal with nonconventional cash flows may lead to incorrect decisions in comparisons of mutually exclusive investments

[net present value] suppose a project has conventional cash flows and a positive NPV. What do you know about its payback? its discounted payback? its profitability index? its IRR? explain

the project will also have a positive NPV for a zero discount rate; the payback period must be less than the project life. discounted payback period is calculated at the same discount rate as is NPV, if NPV is positive- the discounted payback period must be less than the project's life. positive NPV- present value of future cash inflows is greater than the initial investment cost- PI must be greater than 1 positive NPV for a certain discount rate, then it will be zero for some larger discount rate- the IRR must be greater than the required return