Chapter 8: Net Present Value and Other Investment Criteria

Net Present Value Profile

A graphical representation of the relationship between an investment's net present value and various discount rates

Average Accounting Return (AAR)

An investment's average net income divided by its average book value

Multiple Rates of Return

The possibility that more than one discount rate will make the net present value of an investment zero

Profitability Index (PI)

The present value of an investment's future cash flows divided by its initial cost (Also called benefit-cost ratio)

TRUE OR FALSE: a project with non-conventional cash flows will produce two or more IRRs?

True

TRUE OR FALSE: some projects, such as mines, have cash outflows followed by cash inflows and cash outflows again, giving the project multiple internal rates of return?

True- whenever subsequent cash flows are both negative and positive, multiple internal rates of return may occur

Capital Budgeting is probably the most important of the three areas of concern to the financial manager because________.

__________ defines the business of the firm

One of the flaws of the payback period method is that cash flows after the cut off date are ___________.

not considered in the analysis

According to the basic IRR rule, we should____________.

reject a project if the IRR is less than the required return

According to the AAR rule, a project is acceptable if its average accounting return exceeds:

...a target average accounting return

The basic NPV investment rule is;

1. Accept project when the NPV > 0 2. if NPV = 0, accepting or rejecting the project is a matter of indifference (IRR) 3. Reject project of NPV < 0

The Combination MIRR method is used by the Excel MIRR function and uses which of the following?

1. Discounting all cash outflows to time 0 2. A reinvestment rate for compounding 3. A financing rate for discounting 4. Compounding ALL cash flows to the end of the project 5. Compounding cash inflows to the end of the project

Which of the following are reasons why IRR continues to be practiced?

1. IRR proposal can be calculated without knowing the appropriate discount rate 2. Business people prefer to talk about rates of return 3. it is easier to communicate info about proposal with an IRR

If a project has multiple internal rates of return, which of the following methods should be used?

1. NPV 2. MIRR

If a firm is evaluating two possible projects, both of which require the use of the same production facilities, these projects would be considered____________.

Mutually Exclusive

in capital budgeting,_____________________ determines the dollar value of a project to the company

Net Present Value

The profitability index is calculated by dividing....

Present Value of future cash flows by the initial investment

The internal rate of return must be compared to the ______________in order to determine the acceptability of a project

Required Rate of return

Internal Rate of Return (IRR)

The discount rate that makes the net present value of an investment zero

Discounted Cash Flow (DCF) Valuation

a. Calculating the present value of a future cash flow to determine its value today b. The process of valuing an investment by discounting its future cash flows

payback period

the amount of time required for an investment to generate cash flows sufficient to cover its initial costs

Net Present Value (NPV)

the difference between an investment's market value and its cost

Which of the following are weaknesses of the payback period?

1. The value of money principles are ignored 2. Cash flows received after the payback period are ignored 3. The cut off is arbitrary

Which of the following are reasons why IRR continues to be used in practice?

1. businesspeople prefer to talk about rates of return 2. The IRR of a proposal can be calculated without knowing the appropriate discount rate 3. It is easier to communicate information about a proposal with an IRR

Specify variables in the excel NPV function differ from the manner in which they are entered into a financial calculator in which of the following ways;

1. discount rate in excel is entered as a decimal 2. excel NPV function is actually the PV function 3. The range of cash flows specified in excel begins with cash flow #1 and not cash flow 0. 4. with excel NPV function, cash flow #0 must be handled outside of NPV function

In general, NPV is_________.

1. positive for discount rates below IRR 2. Equal to zero when the discount rate equals the IRR 3. negative for discount rates above the IRR

Which of the following methods or calculating MIRR of a project?

1. reinvestment approach 2. discounting approach 3. Combination approach

Mutually Exclusive Investment decisions

a situation where taking one investment prevents the taking of another