chapter 10 Flashcards
Card M1
Card M2
What is the formula for Net Present Value (NPV)?
NPV = Σ (CFₜ / (1 + r)ᵗ) – Initial Outlay
What does NPV stand for?
Net Present Value
What is the decision rule for NPV?
Accept the project if NPV ≥ 0
What is the Payback Period?
The time it takes to recover the initial investment from project cash flows
What is the Discounted Payback Period?
The time it takes to recover the initial investment using discounted cash flows
What is the decision rule for Payback Period?
Accept if PBP ≤ cutoff period
What is the formula for Profitability Index (PI)?
PI = PV of inflows / Initial Outlay
What is the decision rule for PI?
Accept if PI ≥ 1
What does IRR stand for?
Internal Rate of Return
What is IRR?
The discount rate that makes NPV = 0
What is the IRR decision rule?
Accept the project if IRR ≥ required rate of return
What is MIRR?
Modified Internal Rate of Return
Why is MIRR used over IRR?
MIRR solves multiple IRR problems and assumes reinvestment at WACC
What is the EAA (Equivalent Annual Annuity)?
A method to convert NPV into equal annual amounts over a project’s life
What is the formula to find EAA?
EAA = NPV / PVIFA(r,n)
What does PVIFA stand for?
Present Value Interest Factor of an Annuity
What is the primary goal of capital budgeting?
To choose projects that increase firm value (positive NPV)
What are the main capital budgeting tools?
NPV, IRR, MIRR, PI, Payback, DPBP, EAA
What is capital rationing?
When a firm limits capital spending despite having positive NPV projects
What is a crossover point?
The discount rate at which two project NPVs are equal
What is the formula for calculating DPBP between two years?
DPBP = Year X + (Remaining amount / Next year’s discounted CF)
What’s the primary weakness of the payback method?
Ignores TVM and cash flows after cutoff
How is IRR calculated?
Trial and error or financial calculator until NPV = 0
What causes multiple IRRs?
Projects with cash flows that change sign more than once
When does IRR conflict with NPV?
In mutually exclusive projects or non-normal cash flows
What is the required rate of return usually set to?
The firm’s WACC
What does WACC stand for?
Weighted Average Cost of Capital
Mutually exclusive projects have different lifespans. One has higher NPV, the other has higher EAA. Which one do you pick?
✅ Pick the project with higher EAA
Use EAA to compare when projects have unequal lives and are repeatable. NPV alone is misleading in this case.
