Chapter 9 - Net Present Value

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

1) MIRR 2) NPV

Weaknesses of the payback method

1) Cash flows received after the payback period are ignored 2) The cutoff date is arbitrary 3) Time value of money principles are ignored

The steps involved in the discounted payback period

1) Discount the cash flows using the discount rate 2) Add the discounted cash flows 3) Accept if the discounted payback period is less than some prespecified # of years

What are the basic NPV investment rules?

1) If the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference 2) Accept a project if the NPV is greater than zero 3) Reject a project if tis NPV is less than zero

A good capital budgeting criterion must tell us two things. What are they?

1) Is a particular project a good investment? 2) If we have more than one good project, but we can take only one of them, which one should we take? -The NPV criterion can always provide the correct answer to both questions

What are the different criteria's to evaluate proposed investments?

1) NPV 2) Payback period 3) Discounted payback period 4) Average Accounting Return 5) Internal Rate of Return 6)Modified internal rate of return 7) Profitability index ***know how to calculate each of them***

The three attributes of NPV are that it:

1) Uses all the cash flows of a project 2) Discounts the cash flows properly 3) Uses cash flows

What is a mutually exclusive investment decision?

A situation in which taking one investment prevents the taking of another

A project should be ______ if its NPV is greater than zero.

Accepted

For a project with conventional cash flows, the NPV is ______ if the required return is less than the IRR, and it is ______ if the required return is greater than the IRR.

Positive, negative NPV is positive --> if the required return is < IRR NPV is negative --> if the required return is > IRR

The internal rate of return is a function of ______

A project's cash flows

One of the weaknesses of the payback period is that the cutoff date is a(n) ______ standard.

Arbitrary

Capital ____ is the decision-making process for accepting and rejecting projects.

Capital Budgeting

NPV ______ cash flows properly

Discounts

How is the profitability index calculated?

Dividing the present value (PV) of the future cash flows by the initial investment

What is the discounted payback period?

Finds the PV of each cash flow before calculating a payback period.

The payback period can lead to incorrect decisions if it is used too literally because it ______

Ignores cash flows after the cutoff date

The ______ method differs from NPV because it evaluates a project by determining the time needed to recoup the initial investment.

Payback

Net ______ present value is a measure of how much value is created or added today by undertaking an investment.

Present

The payback period method allows lower management to make ______, everyday financial decisions effectively.

Smaller

By ignoring time value, the payback period rule may accept projects with a ______ NPV

Negative

Advantages of the payback period method for management

1) The payback period method is ideal for short projects 2) It allows lower level managers to make small decisions effectively 3) The payback period method is easy to use

With nonconventional cash flows, there is a possibility that more than one discount rate will make the NPV zero. This is called the

Multiple rates of return problem

What is Net Present Value?

NPV is the difference between the market value of an asset and its cost The financial manager acts in the shareholders best interests by identifying and taking positive NPV projects. NPVs must be estimated because there is always the possibility of a poor estimate, financial managers can use multiple criteria for examining projects.

What is the average accounting return rule?

a project is acceptable if its average accounting return exceeds a target average accounting return

The IRR rule can lead to bad decisions for (2) reasons

1) Cash flows are not conventional 2) Projects are mutually exclusive

The present value of all cash flows (after the initial investment) is divided by the ______ to calculate the profitability index.

Initial investment

Opportunity costs are classified as ______ costs.

Relevant

Using the payback period rule will bias toward accepting which type of investment?

Short term investment

The IRR is the discount rate that makes the NPV of a project equal to _______.

Zero

What is the crossover rate?

The rate at which the NPVs of two projects are equal