ch 9 net present value and other investment criteria

Question 1

what makes a good decision criteria?

Answer 1

• 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?

Question 2

net present value

Answer 2

a measure of how much value is created or added today by undertaking an investment

Question 3

steps to determine how much value is created from undertaking an investment

Answer 3

1. estimate the expected future cash flows
2. estimate the required return for projects of this risk level
3. find the present value of the cash flows and subtract the initial investment

Question 4

decision rule/NPV rule

Answer 4

if the NPV is positive, accept the project

Question 5

discounted cash flow (DCF) valuation

Answer 5

estimation of NPV as the difference btw the present value of future cash flows and the cost of the investment

Question 6

decision criteria test - NPV

Answer 6

• 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?

Question 7

payback rule

Answer 7

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

Question 8

decision criteria test - payback

Answer 8

• 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?

Question 9

advantages of payback

Answer 9

• easy to understand
• adjusts for uncertainty of later cash flows
• biased towards liquidity

Question 10

disadvantages of payback

Answer 10

• 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

Question 11

discounted payback period

Answer 11

length of time until the sum of the discounted cash flows equals the initial investment

Question 12

discounted payback rule

Answer 12

accept the project if it pays back on a discounted basis within the specified time

Question 13

how to calculate discounted payback period

Answer 13

• 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

Question 14

decision criteria test - discounted payback

Answer 14

• 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

Question 15

advantages of discounted payback

Answer 15

• includes time value of money
• easy to understand
• does not accept negative estimated NPV investments
• biased towards liquidity

Question 16

disadvantages of discounted payback

Answer 16

• 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

Question 17

average accounting return

Answer 17

= average net income/average book value

Question 18

decision rule - AAR

Answer 18

accept the project is the AAR is greater than a present rate

Question 19

decision criteria test - AAR

Answer 19

• 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

Question 20

advantages of AAR

Answer 20

• easy to calculate
• needed info is usually available

Question 21

disadvantages of AAR

Answer 21

• 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

Question 22

internal rate of return (IRR)

Answer 22

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

Question 23

decision rule - IRR

Answer 23

accept the project if the IRR is greater than the required return

Question 24

decision criteria test - IRR

Answer 24

• 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

Question 25

nonconventional cash flows

Answer 25

when the NPV (cash flows) is negative at the beginning and end of the project
- use NPV rule to decide to reject or accept

Question 26

mutually exclusive projects

Answer 26

if you choose one, you can’t choose the other
- choose project with higher NPV
- choose project with higher IRR

Question 27

cross over rate

Answer 27

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)

Question 28

IRR is unreliable in the following situations

Answer 28

• non-conventional cash flows
• mutually exclusive projects
  therefore whenever there is a conflict, you should always use NPV

Question 29

advantages of IRR

Answer 29

• closely related to NPV, generally leading to identical decisions
• easy to understand and communicate

Question 30

disadvantages of IRR

Answer 30

• may result in multiple answers or no answers with non-conventional cash flows
• may lead to incorrect decisions in comparisons of mutually exclusive investments

Question 31

profitability index

Answer 31

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

Question 32

advantages of profitability index

Answer 32

• closely related to NPV, generally leading to identical decisions
• easy to understand and communicate
• may be useful when available investment funds are limited

Question 33

disadvantages of profitability index

Answer 33

• may lead to incorrect decisions in comparisons of mutually exclusive invesments

Question 34

capital rationing

Answer 34

said to exist when profitable investments are available but there is not enough funds to undertake them

Question 35

soft rationing

Answer 35

limited resources are temporary, often self-imposed

Question 36

hard rationing

Answer 36

additional capital cannot be raised, due to financial distress or pre-existing contractual agreements