LS5

decision rule for project where 1st cash flows are negative (2):

1. accept if IRR < discount rate 2. reject if IRR > discount rate

project with negative initial CF followed by positive CF (2):

1. accept if NPV is greater than 0 2. reject if IRR is less than market rate of financing

2 mutually exclusive projects can be evaluated by (2)

1. comparing NPVs 2. comparing incremental IRR to discount rate

weaknesses of the payback method (3)

1. gives equal weight to all CF before cutoff date 2. CF received after payback period are ignored 3. cutoff date is arbitrary

discount rate of project reflects (2):

1. opportunity cost of investor 2. risk of project

3 attributes of NPV

1. uses CF 2. uses all CF of the project 3. discounts CF properly

what does value additivity mean for a firm (2)

1. value of a firm = combined value of firm's projects, divisions, and entities owned by the firm 2. NPV values of individual projects can be added together

for a project with a positive initial CF followed by negative CF... accept if:

IRR < R

must know discount rate to COMPUTE _________ and to APPLY __________

NPV; IRR

in capital budgeting, the net ________ is the value of a project to the company

PV

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

ZERO

payback rule _______ (accepts/rejects) project if it has a payback period that is less than or equal to a particular cutoff date

accepts

major problem with discounted-payback-period method

arbitrary cutoff date

discounted payback period

capital budgeting decision method that finds the present value of each CF before calculating payback period

type of rationing when firm can't raise more money from capital markets

hard rationing

payback period can lead to incorrect decisions because it...

ignores cash flows after the cutoff date

how does timing and size of CF affect payback method? assume project does pay back within project's lifetime

increase in size of cash inflow will decrease the payback period, all else held constant

NPV of project's CF is divided by __________ to calculate profitability index

initial investment

project with initial cash outflow followed by a cash inflow has an NPV that is ________ (negatively/positively) related to the discount rate

negatively

discount rate

opportunity cost

discount rate also referred to as

opportunity cost

the ________ method differs from the NPV because it evaluates a project by deteriming the time needed to recoup the initial investmentq

payback

For "normal" CF (outflows before inflows), the NPV is ______ if the discount rate is less than the IRR and it is _______ if the discount rate is greater than the IRR

positive; negative

internal rate of return is a function of _________

projects CFs

capital ___________ = firm doesn't have enough capital to fund all its positive NPV projects

rationing

opportunity cost of capital determined by the _________ of the project

risk

most important alternative to NPV

internal rate of return method

steps involved in discount payback period (3)

1. discount CF using discount rate 2. add discounted CF 3. accept if the discounted payback period is less than some pre-specified number of years

2 challenges with IRR approach when comparing 2 projects:

1. scale 2. differing CF patterns over time