Ch7: NPV and Other Investment Rules Flashcards
Positive NPV benefits
NPV
the stockholders
NPV raises the value of the firm
NPV
correct
Discount rate is referred as opportunity cost
NPV
because it takes away the stockholders opportunity to invest in market
Earnings shouldn’t be used in capital budgeting because they don’t represent cash
NPV
correct
BIG companies use Payback method for small investment projects
PAYBACK
NPV : uses cash flow, all relevant cash flows, and discounts them
correct
Payback vs NPV
PAYBACK
payback know results faster vs NPV takes long time
payback: firms with limited access to capital market use this method
PAYBACK
Accpet < arbtitrrary limit set by company
payback
PAYBACK: key terms
No value of money
no discouting
creating value to company - doesn’t care
Shoudn’t consider as primary criteria
Big-ticket decisions , use NPV
small projects, use payback
PAYBACK
Discounted payback: Discount the cashflows and do cut-off
It is poor compromise between the payback and NPV
yes
AAR: Average accounting return
Total net income / Total investment
AAR
Total investment with depreciation. (500 + 400 + 300 + 200 + 100 + 0) / 6. For 5 years, it will be 5 +1.
If company set AAR > 20 then 20 AAR will be rejected.
AAR
yes
AAR drawbacks:
AAR
- They use accounting data like netincome, book value.
- They don’t take account of timing
- No right target rate
- Ignores time value of money
- Not on cashflows and market values
AAR will be used by some managers to select projects that are profitable in the near term even if they are not good long term
AAR
yes
At which NPV becomes zero.
IRR
try with different discount rates and see where NPV becomes zero. That i
Accept IRR > Discount Rate
IRR
NPV will be positive for all discount rates < IRR
IRR
IRR doesn’t use any external rates to calculate
IRR
yes
Pros & Cons
Time value of money: yes
Creating value for the firm: yes
Decision criteria: Maybe
Adjust for risk: Yes
