Chapter 7 Finance

What is the basic IRR rule?

- Accept the project if IRR is greater than discount rate - Reject the project if IRR is less than the discount rate

What is wrong with AAR?

- It uses the net income and book value of the investment, both of which come from the accounting books ( - The basic inputs of AAR method, income and avg investment, are affected by the accountant's judgment. Accounting judgments do not affect cash flows (Does not use actual financial cash flows) - AAR takes no account of timing (does not consider timing of cash flows and ignores the time value of money) - AAR offers no guidance on what the targeted rate of return should be

Why would people use the payback period method? (managerial perspective)

- Used by large companies when making relatively small decisions (buying a warehouse or a tune-up for a truck - lower management) - Payback method allows us to know whether the manager's assessment of cash flows was correct - Firms with good investment opportunities but no available cash would use this method - Rarely used with big decisions - preference still goes to NPV

What is the NPV rule?

-Accept a project if NPV is greater than zero -Reject a project if NPV is less than zero

We can handle any mutually exclusive example in three ways:

1. Compare the NPVs of the two choices 2. Calculate the incremental NPV from making the large-budget picture instead of small-budget picture 3. Compare the incremental IRR to the discount rate

What are the steps in the average accounting return method?

1. Determining Average Net Income: Net income = any net cash flow - depreciation - taxes. Depreciation is not a cash outflow, but rather a charge reflecting the fact that investment in the store becomes less valuable 2. Determining Average Investment: Remember to include investment at Time 0 when dividing 3. Determine AAR: If targeted accounting rate is greater than AAR, project would be rejected. If targeted accounting rate is less than AAR, project would be accepted.

How do we use the profitability index?

1. Independent projects: - Accept an independent project if PI > 1 - Reject if PI < 1 2. Mutually Exclusive Projects - B/c PI is a ratio, the index misses the fact that one project has a larger investment than the other. It ignores differences of scale for mutually exclusive projects (use incremental analysis) 3. Capital rationing (when firm does not have enough capital to fund all positive NPV projects) - in the case of limited funds, we should rank projects according to the ratio of present value to initial investment

The key to NPV is its three attributes:

1. NPV uses cash flows - cash flows from a project can be used for other corporate purposes (dividend payments, other capital budgeting projects, or payments of corporate interest; earnings not included) 2. NPV uses all cash flows of a project 3. NPV discounts the cash flows properly - some approaches may ignore the TVM when handling cash flows

What are the problems with the payback period method?

1. Timing of Cash Flows within the payback period - it does not consider the timing of cash flows within the payback period (Project A increasing in cash flows while B decreases) 2. Payments after the Payback Period - B/c of the short term orientation of the payback method, some long-term projects are likely to be rejected 3. Arbitrary standard for payback period - No comparable guide for choosing the payback cutoff date (using historical returns for risky projects; riskless rate by Treasury instrument for riskless projects)

True or false? The IRR rule is easier to apply than the NPV rule because you don't use the discount rate when applying IRR

False - in order to apply IRR, you need to compare IRR with discount rate. Thus, the discount rate is needed for making a decision under either the NPV or IRR approach

Indivisibilities may reduce the effectiveness of the PI rule

For example, if a firm has $30 million available for capital investment, the firm has enough cash for Projects 1 and 2. Because the sum of the NPVs of these two projects is greater than the NPVs of Projects 2 and 3, firm would be better served by accepting 1 and 2. Projects 1 and 2 use up ALL of the $30 million while Projects 2 and 3 have remaining money left in the bank

What is the IRR?

Internal Rate of Return - It is about as close as you can get to NPV without actually being the NPV -Causes the NPV of the project to be zero

What does accepting a positive NPV do?

It benefits the stockholders

Why do people want IRR?

It fills a need that NPV does not. People want a rule that summarizes the information about a project in a single rate of return

Where does IRR go wrong?

It ignores issues of scale For example, while opportunity 1 has greater IRR, the investment is much smaller.

What is the average accounting return method?

It is the average project earnings after taxes and depreciation, divided by the average book value of investment during its life

What is the profitability index?

It is the ratio of the present value of the future expected cash flows after initial investment divided by the amount of the initial investment

What is the basic rationale behind the IRR method?

It provides a single number summarizing the merits of a project. That number does not depend on the various interest rates prevailing in the capital markets. The number is internal or intrinsic to the project and does not depend on anything except the cash flows of the project.

What does the payback period method tell us?

It tells us when the cash outflow of an investment is "paid back" by cash inflows. If the cutoff is two years then all investment projects that have a payback periods of two years or less are accepted. Rejected if more.

How does MIRR violate the "spirit" of the IRR approach?

MIRR is clearly a function of the discount rate

What is modified IRR?

Method that handles the multiple IRR problem by combining cash flows until only ONE change in sign remains

The value of the firm rises by the...

NPV of the project

What is an independent project?

One whose acceptance or rejection is independent of the acceptance or rejection of other projects

What do we do when the two projects have the same initial investment?

Perform the subtraction so that the first nonzero cash flow is negative

What are some flaws of the discounted payback period method?

Same flaws as the payback period method

What is the value of the firm?

Sum of the values of the different projects, divisions, or other entities within the firm. The contribution of any project to a firm's value is simply the NPV of the project

What is incremental IRR?

The IRR on the incremental investment from choosing the large project instead of the small project

What happens to the IRR with financing?

The decision rule is exactly the opposite. The rule is: Accept the project when IRR is less than the discount rate Reject the project when IRR is greater than the discount rate

What is the discounted payback period method?

The discounted payback period method of the original investment is simply the payback period for these discounted cash flows

True or false? You must know the discount rate to compute the NPV of a project, but you compute the IRR without referring to the discount rate

True - IRR is computed by solving for the rate when NPV is zero

Is AAR used in the business world?

Yes - Frequently used as backup to discounted cash flow methods. Probably because it is easy to calculate and uses accounting numbers that are readily available from firm's accounting system - Some stockholders and media focus on overall profitability of a firm

What are mutually exclusive investments?

You can accept A or you can accept B or you can reject both of them, but you can't accept both of them.

The NPV is negative when discount rates are...

above IRR

The NPV is positive when discount rates are...

below the IRR

The profitability index cannot handle capital rationing over...

multiple time periods

In theory, a cash flow steam with K changes in sign can have...

up to K sensible internal rates of return