chapter 8 Flashcards
what I the NPV decision rule?
when making an investment decision, take the alternative with the highest NPV. choosing this alternative is equivalent to receiving its NPV in cash today
what is the golden rule for investment decisions?
the NPV decision rule
if the NPV is not positive, what do we do?
since doing nothing is NPV 0 than if the project has a negative NPV we reject the investment project
that is the IRR?
the internal rate of return, it is a discounted cashflow technique it represents the discount rate at which the projects NPV is equal to 0
what does the IRR method assume?
it assumes the cash inflows from a project are reinvested at a equal rate to the internal return rate
what does the NPV method assume?
assumes the cash inflows are reinvested at a rate equal to the cost of capital (r)
what is the IRR investment rule?
take any investment opportunity where the IRR is greater than the opportunity cost of capital and turn down any opportunity whose IRR is less than the opportunity cost of capital
what are the 2 complications to accepting or rejecting a project using the IRR and NPV method?
some projects have more than one IRR
some investments and interest rate that sets the NPV equal to 0 will not exist
when would a project have more than 1 IRR?
when future cash flows are negative besides the initial investment
can you use the IRR rule to interpret whether you should accept or reject a project if it has more than 1 IRR?
no, the IRR rule fails here
what is the pay back rule?
it calculates how long it will take to pay back the initial investment
what is the payback period?
the number of years required for a project to recoup its initial investment
say you have a project with an initial investment of 500,000 and cash flows of 100,000 for the next 10 years, how long is the payback period?
it is 5 years before you recoup your initial investment
what is the cut-off period?
a pre-specified time where if you don’t recoup your initial investment within that time, you would not take that project
what are the 2 drawbacks of the payback rule?
it ignores the time value of money
and it ignores all cashflows after the payback period
