Ch 8

Question 0

Discounted cash flow valuation (DCF)

Answer 0

Process of valuing investment by discounting future

Cash flows

Question 1

Net present value (NPV)

Answer 1

Difference btw investment’s market value and it’s cost

Question 2

Net present value rule

Answer 2

An investment should be accepted if net present value

is positive and rejected if negative

Question 3

Payback period

Answer 3

Amt of time required for investment to generate cash flows

Sufficient to recover it’s initial cost

Question 4

Payback rule

Answer 4

Investment is acceptable if it’s calculated payback

Period is less than pre specified # of years

Question 5

3 Advantages of payback period rule?

Answer 5

1 easy to understand

2 adjusts for uncertainty of later cash flows

3 biased toward liquidity

Question 6

4 disadvantages of payback period rule?

Answer 6

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)

Question 7

Average accounting return (AAR)

Answer 7

Average accounting return =
Investment’s average net income/average book value

Or
measure of avg. accounting profit/
measure of avg. accounting value

Question 8

Average accounting return rule

Answer 8

Project is acceptable if avg accounting return exceeds

Target avg accounting return

Question 9

2 advantages of average accounting return?

Answer 9

1 easy to calculate

2 needed info usually available

Question 10

3 disadvantages of average accounting return?

Answer 10

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

Question 11

Internal rate of return (IRR)

Answer 11

Discount rate that makes the NPV of investment 0

Question 12

IRR rule

Answer 12

Investment is acceptable if IRR exceeds required return

It should be rejected otherwise

Question 13

Net present value profile

Answer 13

Graphical representation of relationship btw

investment’s NPV and various discount rates

Question 14

2 conditions that allow IRR and NPV rules to lead to identical decisions?

Answer 14

1 conventional cash flows

2 project must be independent

Question 15

Conventional cash flows?

Answer 15

First cash flow (initial investment is negative)

The rest are positive

Question 16

Project is independent, means?

Answer 16

Decision to accept or reject project does not affect

Decision to accept or reject any other

Question 17

Multiple rates of return

Answer 17

Possibility more than 1 discount rate make NPV of

Investment 0

Question 18

Mutually exclusive investment decisions

Answer 18

Situation where taking one investment prevents taking

Of another

Question 19

If you invest $51 today and get $100 in 1 year and pay $50 in 2 years, what is the IRR on this investment?

Answer 19

There is no IRR

Question 20

2 advantages of internal rate of return?

Answer 20

1 closely related to NPV, often leads to identical decisions

2 easy to understand and communicate

Question 21

Disadvantages of internal rate of return?

Answer 21

1 may result in multiple answers with non conventional
cash flows

2 may lead to incorrect decisions in comparisons
Of mutually exclusive investments

Question 22

Profitability index (PI) AKA Benefit cost ratio equation?

Answer 22

Profitability index=

Present value of investment’s future cash flows/initial cost

Question 23

3 advantages of profitability index?

Answer 23

1 closely related to NPV, generally leading to identical
decisions

2 easy to understand

3 useful when available investment funds are limited