Finance Chapter 9

Payback period rule:

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

When to use payback period rule?

Used by large and sophisticated companies when they are making relatively minor decisions.

Net present value profile

a graphical representation of the relationship between an investment's NPVs and various discount rates.

Average accounting return rule:

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

Mutually exclusive investment decisions

a situation in which taking one investment prevents the taking of another.

Internal rate of return rule:

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

You should take a project with financing type cash flows only

if it is an inexpensive source of financing, meaning that its IRR is lower than your required return.

Average accounting return (AAR)

some measure of average accounting profit / some measure of average accounting value. Specific definition: Average net income / Average book value.

Payback period rule

time value of money is completely ignored. Fails to consider any risk differences. The payback would be calculated the same way for both very risky and very safe projects. Biggest problem is coming up with the right cutoff period: We don't really have an objective basis for choosing a particular number. We end up using a number that is arbitrarily chosen.

Discounted payback rule:

an investment is acceptable if its discounted payback is less than some prespecified number of years. In general, we won't accidentally take any projects with a negative estimated NPV.

Net present value rule:

an investment should be accepted if the net present value is positive and rejected if it is negative. In the unlikely event that the net present value turned out be exactly zero, we would be indifferent between taking the investment and not taking it.

The internal rate of return

the IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate. (discount rate that makes the NPV equal to zero)

Payback period

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

Net present value (NPV) of the investment:

the difference between an investments market value and its cost. Is a measure of how much value is created or added today by undertaking an investment. NPV can be used to determine whether an investment is desirable or not. One way of assessing the profitability of a proposed investment.

Multiple rates of return

the possibility that more than one discount rate will make the NPV of an investment zero.

Profitability Index (PI)

the present value of an investments future cash flows divided by its initial cost. Also called the benefit-cost ratio.

Discounted cash flow (DCF) valuation:

the process of valuing an investment by discounting its future cash flows.

Ignoring time value of money:

may lead to taking investments that are actually worth less than they cost. By ignoring cash flows beyond the cutoff, may be led to reject profitable long-term investments. Using payback period rule will tend to be bias toward shorter-term investments.

What is capital budgeting is all about?

trying to determine whether a proposed investment or project will be worth more, once it is in place, than it costs. Capital budgeting becomes much more difficult when we cannot observe the market price for at least roughly comparable investments.

Internal rate of return

very popular in practice - more so then NPV because people prefer talking about rates of return rather than dollar values. Also because we can't estimate the NPV unless we know the appropriate discount rate, but we can still estimate the IRR.

Discounted payback rule

Rarely used in practice because it really isn't any simpler to use then NPV. Cutoff still is has to be arbitrarily set, and cash flows beyond that point are ignored. As a result, a project with a positive NPV may be found unacceptable because the cutoff is to short. Also, just because one project has a shorter discounted payback than another does not mean it has a larger NPV.

Given two or more mutually exclusive investments, which one is the best?

The best one is the one with the largest NPV.

Do the IRR and NPV rules always lead to identical decisions?

Yes, as long as two very important conditions are met. 1. the project's cash flows must be conventional, meaning that the first cash flow (the initial investment) is negative and al 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. -first condition is usually met but the second is often not.

Discounted payback period

a variation of the payback period, the discounted payback period, fixes this particular problem of ignored time value. Discounted payback period is the length of time until the sum of the discounted cash flows is equal to the initial investment.

Method #2: The reinvestment approach (MIRR)

compound all cash flows (positive and negative) except the first out to the end of the project's life and then calculate the IRR.

Method #1: the discounting approach (MIRR)

discount all negative cash flows back to the present at the required return and add them to the initial cost. Then, calculate the IRR.

Average accounting return (AAR) flaws

ignores time value. It doesn't even look at the right things. Instead of cash flow and market value, it uses net income and book value. These are both poor substitutes. AAR doesn't tell us what the effect on share price will be of taking an investment, so it doesn't tell us what we really want to know.

Payback

is the length of time it takes to recover our initial investment or "get our bait back."

Internal rate of return (IRR)

most important alternative to NPV. IRR is closely related to NPV. With IRR, we try to find a single rate of return that summarizes the merits of a project. We want this rate to be an "internal" rate in which it depends only on the cash flows of a particular invesment. (The discount rate that makes the NPV of an investment zero.)

Method #3: The combination approach (MIRR)

negative cash flows are discounted back to the present, and positive cash flows are compounded to the end of the project.