Chap 5: Investment Evaluation

Question 1

What is payback period?

Answer 1

The number of years required to recover the funds invested in a project from its cash flow

Question 2

What is the decision rule for payback period?

Answer 2

The shorter the payback period, the better the project is

Question 3

What is the advantage of PP?

Answer 3

• provide information about liquidity and risk

Question 4

What are the disadvantages of PP?

Answer 4

1. TVM is ignored
2. Cash flow beyond the payback year are given no consideration
3. No relationship between given payback and investor wealth maximisation

Question 5

What is Net Present Value?

Answer 5

Present value of the project’s free cash flows discounted at the cost of capital

Question 6

What is the decision rules for NPV?

Answer 6

1. Independent projects:
   
   • NPV>0, accept the project
2. Mutually exclusive projects:
   
   • accept the project with the highest positive NPV, if
     no projects has a positive NPV, reject all of them

Question 7

What is profitability index?

Answer 7

• measures the ratio between the present value of future cash flows and the initial investment
• used to make comparisons of projects with different sizes
• equal to the pv of cash flows divided by the initial cash outflows

Question 8

What is the decision rule of PI?

Answer 8

Accepts project if the PI is greater than 1
* when PI is greater than one, it implies that the PV of cash flows is greater than the absolute value of the initial cash outflows

Question 9

What are the decision rules of IRR?

Answer 9

1. Independent projects:
   - IRR>project’s WACC, accept the project, otherwise reject
2. Mutually exclusive projects:
   • accept the project with the highest IRR, provided that IRR is greater than WACC, otherwise reject