Chapter 8: Investment Decision Rules

Question 1

How much value is created from undertaking an investment? (3 Steps)

Answer 1

• first step is to estimate the expected future cash flows
• second step is to estimate the required return for projects of this risk level
• third step is to find the present value of the cash flows and subtract the initial investment

Question 2

NPV Decision Rule

Answer 2

• if the NPV is positive, accept the project
• positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners
• since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal

Question 3

How long does it take to get the initial cost back in a nominal sense?

Answer 3

• estimate the cash flows
• subtract the future cash flows from the initial cost until the initial investment has been recovered

Question 4

Payback Decision Rule

Answer 4

accept if the payback period is less than some preset limit

Question 5

Advantages of Payback

Answer 5

• easy to understand
• adjusts for uncertainty of later cash flows
• biased towards liquidity

Question 6

Disadvantages of Payback

Answer 6

• ignores the time value of money
• requires an arbitrary cutoff point
• ignores cash flows beyond the cutoff date
• biased against long-term projects, such as research and development, and new projects

Question 7

How to Compute Discounted Payback Period

Answer 7

• compute the present value of each cash flow and then determine how long it takes to payback on a discounted basis
• compare to a specified required payback period

Question 8

Discounted Payback Period Decision Rule

Answer 8

accept the project if it pays back on a discounted basis within the specified time

Question 9

Advantages of Discounted Payback

Answer 9

• includes time value of money
• easy to understand
• does not accept negative estimated NPV investments
• biased towards liquidity

Question 10

Disadvantages of Discounted Payback

Answer 10

• may reject positive NPV investments
• requires an arbitrary cutoff point
• ignores cash flows beyond the cutoff date
• biased against long-term projects, such as R&D, and new projects

Question 11

Internal Rate of Return (IRR)

Answer 11

the return that makes the NPV = 0

Question 12

IRR Decision Rule

Answer 12

accept the project if the IRR is greater than the required return

Question 13

IRR Investment Rule

Answer 13

• take any investment where the IRR exceeds the cost of capital
• turn down any investment whose IRR is less than the cost of capital

Question 14

Advantages of IRR

Answer 14

• knowing a return is intuitively appealing
• it is a simple way to communicate the value of a project to someone who doesn’t know all the estimation details
• if the IRR is high enough, you may not need to estimate a required return, which is often a difficult task
• generally leads to the same answers as the NPV method

Question 15

Disadvantages of IRR

Answer 15

• NPV and IRR will generally give us the same decision
• may result in multiple answers or no answer with non-conventional cash flows
• may lead to incorrect decisions in comparisons of mutually exclusive investments

Question 16

Mutually exclusive projects

Answer 16

if you choose one, you can’t choose the other

ex. you can choose to attend graduate school next year at either Harvard or Stanford, but not both

Question 17

Intuitively using NPV and IRR decision rules

Answer 17

• NPV – choose the project with the higher NPV
• IRR – choose the project with the higher IRR

Question 18

Conflicts Between NPV and IRR

Answer 18

• NPV directly measures the increase in value to the firm
• Whenever there is a conflict between NPV and another decision rule, you should always use NPV

Question 19

When IRR is unreliable

Answer 19

• non-conventional cash flows
• mutually exclusive projects

Question 20

Capital rationing

Answer 20

occurs when a firm or division has limited resources

Question 21

Soft Rationing

Answer 21

the limited resources are temporary, often self-imposed

Question 22

Hard Rationing

Answer 22

additional capital that cannot be raised due to financial distress or pre-existing contractual agreements

Question 23

Profitability Index

Answer 23

• measures the benefit per unit cost, based on the time value of money
• useful in situations where we have limited capital (capital rationing)

ex. a profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value

Question 24

Advantages of Profitability Index

Answer 24

• closely related to NPV, generally leading to identical decisions
• easy to understand and communicate
• may be useful when available investment funds are limited

Question 25

Disadvantages of Profitability Index

Answer 25

• may lead to incorrect decisions in comparisons of mutually exclusive investments

Question 26

What is commonly used primary investment criteria?

Answer 26

NPV and IRR

Question 27

What is commonly used secondary investment criteria?

Answer 27

payback