CH 5: Net Present Value and Other Investment Rules Flashcards
What are some benefits to using NPV?
- uses all cash flows
- discounts the cash flows properly
What is the minimum acceptance criteria for NPV?
must be positive
What is the ranking criteria for NPV?
choose highest
What is the payback period?
how long it takes for a project to recover its initial investment
What is the minimum acceptance criteria for payback period?
arbitrary amount set by management
What is the ranking criteria for payback period?
set by management
What are some disadvantages of using the payback period method?
- ignores the time value of money
- ignores cash flows after the payback period
- biased against long term projects
- requires an arbitrary acceptance criteria
- project accepted based on payback may be rejected by NPV
What are some advantages to using the payback period method?
- easy to understand
- biased toward liquidity
- helpful in assessing lower management
What is the discounted payback period?
how long it takes to recover initial investment while considering the time value of money
What is the internal rate of return (IRR)?
discount rate that sets NPV to zero
What are some limitations for using IRR?
- multiple changes of signs
- scaling
What is the Profitability Index?
Total PV of future cash flows / initial investment
What is the minimum acceptance criteria for PI?
accept if PI > 1
What is the ranking criteria for PI?
select alternative with highest PI
What is the disadvantage of using PI?
problems with mutually exclusive investments
