Chapter 9-Net Present Value

The basic NPV investment rule is:

1. Reject a project if its NPV is less than zero 2. Accept a project if its NPV is greater than zero 3. If the NPV is equal to zero, acceptance or reject ace of the project is a matter of indifference

Which of the following is acceptable if the average accounting return is required to be at least 20%?

1. Restaurant: average income: $450,000, average book value: $2,180,000 2. Book store: average income=$140,000, average book value= $600,000

What are the advantages of the payback period method for management?

1. the payback period method is easy to use 2. it allows lower level managers to make small decisions effectively 3. the payback period method is ideal for short projects

Saxon company is considering a project that will generate net income of $5,000 in year 1, $75,000 in year 2, and $90,000 in year 3. The cost of the project is $700,000, and this cost will be depreciated to zero in the 3 years of the investment. What is their average accounting return?

20.48%

How does the timing and the size of cash flows affect the payback method? Assume the project does pay back within the project's lifetime.

An increase in the size of the first cash inflow will decrease the payback period, all else held constant

According to Graham and Harvey's 1999 survey of 392 CFOs, which of the following two capital budgeting methods are most used by firms in the US?

IRR and NPV

Capital corp is considering a project whose internal rate of return is 14%. If capital's required return is 14%, the project's NPV is ?

Zero

IRR rule

an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.

The point at which the NPV profile crosses the vertical axis is the :

sum of the cash flows of the project

Crossover rate

the discount rate that makes the NPVs of two projects equal

What is the NPV of a project with an initial investment of $95, a cash flow in one year of $107, and a discount rate of 6%?

$5.94

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

1 MIRR 2NPV

Disadvantages of IRR

1) may result in multiple answers with nonconventional cash flows 2) may lead to incorrect decisions in comparisons of mutually exclusive investments

Which of the following are advantages of AAR?

1. It is easy to compute 2. Needed info is usually available

Disadvantages of discounted payback method

1. May reject positive NPV investments 2. Requires an arbitrary cutoff point 3. Ignores cash flows beyond the cutoff date 4. Biased against long-term projects, such as research and development, and new projects

Disadvantages of the average accounting return

1. Not a true rate of return; time value of money is ignored 2. Uses an arbitrary bench arch cutoff rate 3. Based on accounting (book) values, not cash flows and market values

What is the IRR for a project with an initial investment of $250 and subsequent cash inflows of $100 per year for 3 years?

9.70%

What is a benefit-cost ratio?

A ratio comparing the PV of future cash flows to initial investment cost

Mutually exclusive investment decsions

A situation in which taking one investment prevents the taking of another (the project with the largest NPV is the best)

The PI rule for an independent project is to ? The project if the PI >1

Accept

NPV rule

An investment should be accepted if the net present value is positive and rejected if it is negative.

Capital ? Is the decision-making process for accepting and rejecting projects

Budgeting

What is an advantage of the average accounting return method of project analysis>

Easy to calculate

Investing more money in a project will always lead to a greater profit

False

The MIRR function eliminates multiple IRRs and should replace NPV.

False

The PI is calculated by dividing the PV of the ? Cash flows by the initial investment

Future

A(n) ? Project doe snot rely on the acceptance or rejection of another project.

Independent

The PV of all cash flows (after initial investment) is divided by the ? To find PI

Initial investment

The most important alternative to NPV is the ? Method

Internal rate of return

A drawback of the payback method of project analysis is

It ignores the time value of money

The net present value rule states that you should accept a project if its net present value is ?

Positive

Profitability index or benefit cost ratio

Present value of the future cash flows divided by the initial investment

Project Alpha's NPV profile crosses the vertical axis at $230,000. Project Beta's NPV profile crosses the vertical axis at $150,000. If Project Alpha and Project Beta have conventional cash flows, are mutually exclusive, and the NPV profiles cross at 15%(where the NPVs are positive), which of the projects has a higher internal rate of return?

Project Beta-lower $ to have the same discount rate

The IRR rule can lead to bad decisions when ?

Projects are mutually exclusive or cash flows are not conventional

If the IRR is greater than the ?, we should accept the project.

Required return

IRR

Required return that results in a zero NPV when it is used as the discount rate (sometimes called them discounted cash flow return)

In which of the following scenarios would IRR always recommend the wrong decision?

Starting cash flow: $1000, ending cash flow:-$2,000

Based on discounted payback period rule, an investment is acceptable if its discounted payback period is less than some prespecified number of years.

True

Some projects, such as mines, have cash outflows followed by cash inflows, which are then followed by cash outflows, giving the project multiple rates of return.

True

The crossover rate is the rate at which the NPVs of two projects are equal.

True

The internal rate of return is a function of ?

a project's cash flows

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

a target average accounting return

Payback rule

an investment is acceptable if its calculated payback period is less than some prespecified number of years

Discounted payback rule

an investment is acceptable if its discounted payback is less than some prespecified number of years

The point at which the NPV profile crosses the horizontal axis is the

internal rate of return

IRR continues to be very popular in practice partly because:

it gives a rate of return rather than a dollar value

Discounted payback period

length of time until the sum of the discounted cash flows is equal to the initial investment

This capital budgeting method allows lower management to make smaller, everyday financial decisions effectively.

payback method

The amount of time needed for the cash flows from an investment to pay for its initial cost is the

payback period

Payback period tells the time it takes to break even in an ? Sense. Discounted payback period tells the time it takes to break even in an ? Or financial sense.

Accounting; economic

Average accounting return

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

The discounted payback period for a project will be ? The payback period for the project given a positive, non-zero discount rate

Less than

Target rate (hurdle rate)

Minimally accepted rate

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

Negative

When cash flows are conventional, NPS is ? If the discount rate is above the IRR

Negative

In capital budgeting, the ? Determines the value of a project to the company.

Net present value

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

Net present value of the investment

IRR approach may lead to incorrect decisions in comparison of two mutually exclusive projects.

True

Advantages of the average accounting return

1. Easy to calculate 2. Needed information will usually be available

Advantages of payback period riule

1. Easy to understand 2. Adjusts for uncertainty of later cash flows 3. Bias toward liquidity

The discounted payback period has which of these weaknesses?

1. Exclusion of some cash flows 2. Arbitrary cutoff date 3. Loss of simplicity as compared to the payback method

Advantages of discounted payback method

1. Includes time value of money 2. Easy to understand 3. Does not accept negative estimated NPV investments 4. Biased towards liquidity

What method of analysis tends to be least utilized by CFOs, according to the survey conducted in 1999 in your textbook?

PI

Payback period

the amount of time required for an investment to generate cash flows sufficient to recover its initial cost

When cash flows are conventional, NPV is:

1. Positive for discount rates below the IRR 2. Negative for discount rates below the IRR 3. Equal to zero when the discount rate equal the IRR

Shortcomings of payback rule

1)by ignoring time value, we may be lead to take investments that actually are worth less they cost. 2) by ignoring cash flows beyond cut off, we may be lead to reject profitable longer-term investments (using a payback period rule will tend to bias us toward shorter term investments)

The IRR and NPV rules always lead to identical decisions if:

1- the project's cash flows must be conventional (meaning the first cash flow or initial investment is negative and all the rest are positive) 2- the project must be independent (meaning that the decision to accept or reject this project does not affect the decision to accept or reject any other)

Which of the following are mutually exclusive investments?

1. A restaurant or gas station on the same piece of land 2. Two different choices for the assembly lines that will make the same product

Which of the following are weaknesses of the payback period?

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

Advantages of IRR

1. Closely related to NPV, often leading to identical decisions 2. Easy to understand and communicate

arrange the steps involved in the discounted payback period in order starting with the first step

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 pre-specified number of years

The three attributes of NPV are that it:

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

The spreadsheet function for calculating net present value is:

=NPV

A project should be ? If it's NPV is >0.

Accepted

Disadvantages of payback period rukle

1. Ignores the time value of money 2. Requires an arbitrary cutoff period 3. Ignores cash flows beyond cut off date 4. Biased against long term projects, such as research and development, and new projects

The payback period rule suggests ? A project if it has a payback period that is less than or equal to a particular cut off date

Accepting