ch 9 net present value and other investment criteria Flashcards
what makes a good decision criteria?
- does the decision rule adjust for the time value of money?
- does the decision rule adjust for risk?
- does the decision rule provide info on whether we are creating value for the firm?
net present value
a measure of how much value is created or added today by undertaking an investment
steps to determine how much value is created from undertaking an investment
- estimate the expected future cash flows
- estimate the required return for projects of this risk level
- find the present value of the cash flows and subtract the initial investment
decision rule/NPV rule
if the NPV is positive, accept the project
discounted cash flow (DCF) valuation
estimation of NPV as the difference btw the present value of future cash flows and the cost of the investment
decision criteria test - NPV
- does the NPV rule account for the time value of money?
- does the NPV rule account for the risk of the cash flows?
- does the NPV rule provide an indication about the increase in value?
- should we consider the NPV rule for our primary decision criteria?
payback rule
how long does it take to get the initial cost back in a nominal sense?
- estimate the cash flows
- subtract the future cash flows from the initial cost until the initial investment has been recovered
decision criteria test - payback
- does the payback rule account for the time value of money?
- does the payback rule account for the risk of the cash flows?
- does the payback rule provide an indication about the increase in value?
- should we consider the payback rule for our primary decision criteria?
advantages of payback
- easy to understand
- adjusts for uncertainty of later cash flows
- biased towards liquidity
disadvantages of payback
- ignores the time value of money
- requires an arbitrary cutoff point
- ignores cash flows beyond the cutoff date
- biased against long-term projects, such as research and development, and new projects
- ignores any risks associated with projects
discounted payback period
length of time until the sum of the discounted cash flows equals the initial investment
discounted payback rule
accept the project if it pays back on a discounted basis within the specified time
how to calculate discounted payback period
- compute the present value of each cash flow and then determine how long it takes to payback on a discounted basis
- compare to a specified required payback period
decision criteria test - discounted payback
- does the discounted payback rule account for the time value of money
- does the discounted payback rule account for the risk of cash flows
- does the discounted payback rule provide an indication about the increase in value
- should we consider the discounted payback rule for our primary decision criteria
advantages of discounted payback
- includes time value of money
- easy to understand
- does not accept negative estimated NPV investments
- biased towards liquidity
disadvantages of discounted payback
- may reject positive NPV investments
- requires an arbitrary cutoff point
- ignores cash flows beyond the cutoff date
- biased against long-term projects, such as research and development, and new projects
average accounting return
= average net income/average book value
decision rule - AAR
accept the project is the AAR is greater than a present rate
decision criteria test - AAR
- does the AAR rule account for the time value of money
- does the AAR rule account for the risk of the cash flows
- does the AAR rule provide an indication about the increase in value
- should we consider the AAR rule for our primary decision criteria
advantages of AAR
- easy to calculate
- needed info is usually available
disadvantages of AAR
- not a true rate of return; time value of money is ignored
- uses an arbitrary benchmark cutoff rate
- based on accounting net income and book values, not cash flows and market value
internal rate of return (IRR)
single rate of return that summarizes the merits of a project
- depends only on the cash flows of a particular investment
- the return that makes the NPV=0
decision rule - IRR
accept the project if the IRR is greater than the required return
decision criteria test - IRR
- does the IRR rule account for the time value of money
- does the IRR rule account for the risk of the cash flows
- does the IRR rule provide an indication about the increase in value
- should we consider the IRR rule for our primary decision criteria
nonconventional cash flows
when the NPV (cash flows) is negative at the beginning and end of the project
- use NPV rule to decide to reject or accept
mutually exclusive projects
if you choose one, you can’t choose the other
- choose project with higher NPV
- choose project with higher IRR
cross over rate
the discount rate that makes the NPVs of two projects equal
NPV (B-A) = 0 = (difference in investment) + (difference in profit or loss in first year/(1+r)) + (difference in profit or loss in second year/(1+r)^2)
IRR is unreliable in the following situations
- non-conventional cash flows
- mutually exclusive projects
therefore whenever there is a conflict, you should always use NPV
advantages of IRR
- closely related to NPV, generally leading to identical decisions
- easy to understand and communicate
disadvantages of IRR
- may result in multiple answers or no answers with non-conventional cash flows
- may lead to incorrect decisions in comparisons of mutually exclusive investments
profitability index
present value of the future cash flows divided by the initial investment
- measure the benefit per unit cost, based on the time value of money
advantages of profitability index
- closely related to NPV, generally leading to identical decisions
- easy to understand and communicate
- may be useful when available investment funds are limited
disadvantages of profitability index
- may lead to incorrect decisions in comparisons of mutually exclusive invesments
capital rationing
said to exist when profitable investments are available but there is not enough funds to undertake them
soft rationing
limited resources are temporary, often self-imposed
hard rationing
additional capital cannot be raised, due to financial distress or pre-existing contractual agreements
