Ch 8 Flashcards
Discounted cash flow valuation (DCF)
Process of valuing investment by discounting future
Cash flows
Net present value (NPV)
Difference btw investment’s market value and it’s cost
Net present value rule
An investment should be accepted if net present value
is positive and rejected if negative
Payback period
Amt of time required for investment to generate cash flows
Sufficient to recover it’s initial cost
Payback rule
Investment is acceptable if it’s calculated payback
Period is less than pre specified # of years
3 Advantages of payback period rule?
1 easy to understand
2 adjusts for uncertainty of later cash flows
3 biased toward liquidity
4 disadvantages of payback period rule?
1 ignores time value of money
2 requires arbitrary cutoff point
3 ignores cash flows beyond cutoff date
4 biased against long term projects (R&D, new projects)
Average accounting return (AAR)
Average accounting return =
Investment’s average net income/average book value
Or
measure of avg. accounting profit/
measure of avg. accounting value
Average accounting return rule
Project is acceptable if avg accounting return exceeds
Target avg accounting return
2 advantages of average accounting return?
1 easy to calculate
2 needed info usually available
3 disadvantages of average accounting return?
1 not true rate of return; time value of money ignored
2 uses arbitrary benchmark cutoff rate
3 based on accounting net income and book values
Instead of cash flows and market values
Internal rate of return (IRR)
Discount rate that makes the NPV of investment 0
IRR rule
Investment is acceptable if IRR exceeds required return
It should be rejected otherwise
Net present value profile
Graphical representation of relationship btw
investment’s NPV and various discount rates
2 conditions that allow IRR and NPV rules to lead to identical decisions?
1 conventional cash flows
2 project must be independent
Conventional cash flows?
First cash flow (initial investment is negative)
The rest are positive
Project is independent, means?
Decision to accept or reject project does not affect
Decision to accept or reject any other
Multiple rates of return
Possibility more than 1 discount rate make NPV of
Investment 0
Mutually exclusive investment decisions
Situation where taking one investment prevents taking
Of another
If you invest $51 today and get $100 in 1 year and pay $50 in 2 years, what is the IRR on this investment?
There is no IRR
2 advantages of internal rate of return?
1 closely related to NPV, often leads to identical decisions
2 easy to understand and communicate
Disadvantages of internal rate of return?
1 may result in multiple answers with non conventional
cash flows
2 may lead to incorrect decisions in comparisons
Of mutually exclusive investments
Profitability index (PI) AKA Benefit cost ratio equation?
Profitability index=
Present value of investment’s future cash flows/initial cost
3 advantages of profitability index?
1 closely related to NPV, generally leading to identical
decisions
2 easy to understand
3 useful when available investment funds are limited