Chapter 8 - Net Present Value Flashcards
What is the net present value?
It is the present value of cash flows minus the initial investment
What is the opportunity cost of capital?
The expected rate of return given up by investing in a project
Managers increase shareholders’ wealth by accepting all projects that are worth _____ than they _____
more ; cost
(Positive net value)
What are the 4 investment criteria/measures other than NPV?
Payback
Discounted Payback
Internal Rate of Return (IRR)
Profitability Index
What is the payback?
The time period it takes for the cash flows generated by the project to cover the initial investment in the project
What is the payback rule?
Accept a project if the payback period is less than the specified cutoff period
What are 2 problems with Payback?
- Ignores cash flows after the payback
- Doesn’t take into account time value of money
What is the discounted payback?
What does it solve?
The time period it takes for discounted cash flows to cover the initial investment in the project
It solves the problem of time value of money
(but still ignores cash flows after payback)
What is the Internal Rate of Return (IRR)
The discount rate at which the NPV of the project equals 0
What is the IRR rule?
Accept a project if it offers a rate of return higher than the opportunity cost of capital
What is a situation when the IRR rule would not work?
When some projects have more than one discount rate at which the NPV = 0
True or False
A higher IRR means a higher NPV
False
e.g., 50% of $1 is not better than 10% of $100
What are the 3 challenges when choosing between competing projects?
- Investment timing decision
- Choice between long-lived, vs short-lived equipment
- Replacement problem
What is the optimal investment timing decision?
The investment date that results in the highest NPV today
What is the Equivalent Annual Cost equation?
EAC = PV / PVAF(%, year)
