chapter 10

If a project is acceptable using the IRR criterion,

, it will also be acceptable using the MIRR criterion.

When several sign reversals in the cash flow stream occur,

a project can have more than one IRR.

The profitability index provides

an advantage over the net present value method by reporting the present value of benefits per dollar invested.

IRR should not be used to choose

between mutually exclusive projects.

Many firms today continue to use the payback method

but also employ the NPV or IRR methods especially when large projects are being analyzed

Both the profitability index (PI) and net present value (NPV) are based on the present value of all future free cash flows,

but the PI is a relative measure while the NPV is an absolute measure of a project's desirability

NPV is the most theoretically correct

capital budgeting decision tool examined in the text.

The payback period may be more appropriate to use for

companies experiencing capital rationing.

Two potential approaches to capital budgeting decision are a

deterministic approach and a probabilistic approach.

Any project deemed acceptable using the

discounted payback period will also be acceptable if using the traditional payback period.

The profitability index can be helpful when a financial manager

encounters a situation where capital rationing is required.

Whenever the internal rate of return on a project

equals that project's required rate of return, the net present value equals zero.

The internal rate of return is the discount rate that

equates the present value of the project's future free cash flows with the project's initial outlay

The size disparity problem occurs when mutually

exclusive projects of unequal size are being examined

An acceptable project should have a net present value

greater than or equal to zero and a Profitability Index greater than or equal to one.

A project's net present value profile shows

how sensitive the project is to the choice of a discount rate.

The net present value of a project will

increase as the required rate of return is decreased (assume only one sign reversal).

A project's IRR

is analogous to the concept of the yield to maturity for bonds.

Advantages of the payback period

is easy to calculate, easy to understand, and that it is based on cash flows rather than on accounting profits.

A major disadvantage of the discounted payback period

is the arbitrariness of the process used to select the maximum desired payback period.

If a project is acceptable using the NPV criteria,

it will also be acceptable when using the profitability index and IRR criteria.

The main disadvantage of the NPV method is the need for detailed,

long-term forecasts of free cash flows generated by prospective projects.

If a project's profitability index is less than

one then the project should be rejected.

An infinite-life replacement chain allows

projects of different lengths to be compared.

Free Cash flows

represent the benefits generated from accepting a capital-budgeting proposal.

The discounted payback period takes the time value of money into account in that it uses discounted free cash flows rather

than actual undiscounted free cash flows in calculating the payback period.

One of the disadvantages of the payback method is

that it ignores time value of money

One drawback of the payback method is

that some cash flows may be ignored.

A project's equivalent annual annuity (EAA) is

the annuity cash flow that yields the same present value as the project's NPV.

If a firm imposes a capital constraint on investment projects,

the appropriate decision criterion is to select the set of projects that has the highest positive net present value subject to the capital constraint.

A project with a payback period of four years is acceptable as long as

the company's target payback period is greater than or equal to four years.

The required rate of return reflects

the costs of funds needed to finance a project.

The internal rate of return will equal

the discount rate when the net present value equals zero.

The capital budgeting decision-making process involves measuring

the incremental cash flows of an investment proposal and evaluating the attractiveness of these cash flows relative to the project's cost.

For a project with multiple sign reversals in its cash flows,

the net present value can be the same for two entirely different discount rates.

The internal rate of return is the discount rate that equates

the present value of the project's free cash flows with the project's initial cash outlay.

The modified internal rate of return represents

the project's internal rate of return assuming that intermediate cash flows from the project can be reinvested at the project's required

The profitability index is

the ratio of the present value of the future free cash flows to the initial investment.

If the net present value of a project is zero,

then the profitability index will equal one.

For any individual project, if the project is acceptable based on its internal rate of return,

then the project will also be acceptable based on its modified internal rate of return.

If a project's IRR is equal to its required return,

then the project's NPV is equal to zero and its PI is equal to one.

If a project's internal rate of return is greater than the project's required return,

then the project's profitability index will be greater than one.

Positive NPV projects may be rejected

when capital must be rationed.

One positive feature of the payback period is it emphasizes the earliest forecasted free cash flows,

which are less uncertain than later cash flows and provide for the liquidity needs of the firm.

NPV assumes reinvestment of intermediate free cash flows at the cost of capital,

while IRR assumes reinvestment of intermediate free cash flows at the IRR.

A project that is very sensitive to the selection of a discount rate

will have a steep net present value profile.