Chapter 7: Investment Decision Rules Concept

What is the internal rate of return

-most important alternative to the NPV method -summarizes the merit of the project - Does not depend on the various interest rates prevailing in the capital markets

What are the problems with AAR

1. Accounting numbers are arbitrary 2. Takes no accounty of timing 3. Arbitrary cutoff date

List the three steps of the Average Accounting Return Method

1. Determine average net income 2. Determine average investment - divide by the # of years + 1 because of beginning of 5 years - sum of all residual value post depreciation divided by the number of years plus 1 3. Determining AAR - Average Net Income/ Average Investment

What are the problems with Payback Period Method

1. Doesn't take time value of money into consideration 2. Payments after the Payback period. They will be overlooked because of the short term orientation 3. No comparable guide for payback period

What is the payback period method

1. Initial outflow 2. Cut off period is however many years it takes to recover the initial outflow

what are the 3 key attributes to NPV

1. Uses cash flow 2. Uses all of the cash flow of the project 3. NPV discounts cash flows properly

What do you do when there are multiple rates of return

1. accept only projects with discount rates that yield positive NPV 2. CF is discounted and combined until there is one change of signs

What is the general rule with IRR

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

What is the relationship between IRR and NPV

IRR is the rate that causes the NPV of the project to be zero

What is the formula for profitability index

PV of CF after initial investment/ Initial investment

What is the Cut off period

Payback period method's # of years it takes to match the initial cash outflow

What is Profitability Index

Ratio of the present value of future expected cash flows after the initial investment DIVIDED by the initial investment

What are the problems for mutually exclusive projects?

Scale

What is Discounted Payback Period Method?

Variation of the payback period method. Takes time value of money into consideration

What is the general rule for NPV

accept if NPV is over 0 and reject if NPV is less than 0

What is the general rule for PI

accept if greater than 1, reject if less than 1

Independent

accepting and rejecting a project is independent of acceptance and rejection of other projects

What is value additivity

contribution of any project to a firm's value is the NPV of the project. not true for other

What would Payback Period Method be good for?

small decisions

For discounted payback period method, as long as CF is positive, discount payback period will never be __________ than payback period

smaller

What is capital budgeting

the decision making process for accepting or rejecting projects

What happens with IRR rule when it's financing instead of investing?

the rule is reversed. you accept a project if the IRR is less than the discount rate

Dollar received _______ is worth ______ than the dollar received ____________

today, more, tomorrow

Mutually exclusive

you can build an apartment or a hotel, but you can't do both on the same lot