Ch 9

Question 0

Net Present Value (NPV)

Estimated by using the discounted cash flow valuation where we evaluate an investment by discounting its future cash flows

Answer 0

The difference between and investments market value and it’s cost

Adjust for the time value of money

Adjust for risk

Provides information on whether value is created for the firm

Question 1

Capital budgeting

Answer 1

Planning and managing a firms investment and fixed assets

Trying to determine whether a proposed investment or project will be worth more than it costs once it is in place

Question 2

The payback rule: payback period

Answer 2

The amount of time for an investment to generate cash flows that equal the cost of the investment

Ignores time value of money and any risk
Biased against long term investments
Arbitrary cutoff point
Biased for short term investments

Question 3

Discounted payback rule

Answer 3

The amount of time for investment to generate cash flow’s who’s discounted value is equal to the cost of the investment

Includes time value of money and rejects negative NPV. Biased for short term investments.

May reject positive and NPV investments.
arbitrary cut off point. Biased against long-term investments. Ignores risk

Question 4

Average Accounting Return (AAR)

Answer 4

Avg net income/avg book value

A project is acceptable if it’s AAR exceeds a target AAR

Not a true rate of return, time value of money is ignored. Arbitrary cut off rate. Based on accounting book values and not cash flows and market values

Question 5

Profitability index

Answer 5

Present value of future cash flows/initial cost

Also called benefit/cost ratio; higher the better

The PI measures the value created per dollar invested

May lead to incorrect decisions in mutually exclusive investments

Question 6

Internal rate of return (IRR)

Answer 6

Discount rate that makes NPV = 0

Accept project if IRR exceeds the required return

IRR and NPV Will lead to similar decisions only if the cash flows are conventional ( 1st one negative and all other positive) and the project must be independent.

Cons: may result in multiple answers of cash flow is unconventional (negative). May lead to incorrect decision for mutually exclusive investments

IRR is useful when you are unsure of an appropriate discount rate

Question 7

Forecasting risk (or estimation risk)

Answer 7

The possibility that errors in projected cash flows lead to incorrect decisions