Chapter 5 - Net Present Value and Other Investment Criteria

Question 1

Net Present Value (NPV) rules

Answer 1

1. A dollar today is worth more than a dollar tomorrow
2. NPV depends solely on the forecasted cash flows from the project and the opportunity cost of capital.
3. Because present values are all measured in today’s dollars, we can add them up. Therefore, if we have two projects A and B, the NPV of the combined investiment is NPV (A+B) = NPV(A) + NPV(B)

Question 2

What is the Payback rule?

Answer 2

The Payback rule states that a project should be accepted if its payback period os less than some specified cutoff period.
“We are spending $6 a week, or around $300 a year, at the laundromat. If we bought a washing machine for $ 800, it would pay for itself within three years.” In this example, if the cutoff period is four years, the washing machine makes the grade; if the cutoff is two years, it doesn’t.
The payback payback period is found by counting the number of years it takes before the cumulative cash flow equals the initial investment.

Question 3

Why payback can give misleading answers?

Answer 3

1. The payback rule ignores all cash flows after the cutoff period.
2. The payback rule gives equal weight to all cash flows before the cutoff date.

Question 4

Internal Rate of Return (IRR)

Answer 4

The discounted-cash-flow (DCF) rate of return or internal rate of return (IRR) is the discount rate that gives a zera NPV.
The IRR is a profitability measure that depends solely in the amount and timing of the cash flows. The opportunity cost of capital is a standard of profitability that we use to calculate how much the project is worth.
The IRR rule is to accept an investment project if the opportunity cost of capital is less than the internal rate of return.

Question 5

Describe the IRR rule pitfalls

Answer 5

1. Lending or borrowing? If a project offers positive cash flows followed by negative cash flows, NPV can rise as the discount rate is increased. You should accept such projects if their IRR is less than the opportunity cost of capital.
2. Multiple rates of return - If there is more than one change in the sign of the cash flows, the project may have several IRRs or no IRR at all.
3. Multually exclusive projects - The IRR may give the wrong ranking of mutually exclusive projects that differ in economic life or in scale or required investment. If you insist on using IRR to rank mutually exclusive projects, you must examine the IRR on each incremental investment.
4. The cost of capital for near-term cash-flows nay be diferrent from the cost for distant cash flows. The IRR rule requires you to compare the project’s IRR with the opportunity cost of capital. But sometimes there is an opportunity cost of capital for one-year cash flows, a different cost of capital for two-years cash-flows, and so on. In these cases there is no simple yardstick for evaluating the IRR of a project.