chapter 8 - Net Present Value

Question 1

capital budgeting decision def

Answer 1

• which projects should the firm invest in?
• known as the capital budgeting decision or the investment decision
  -many criteria available to evaluate investments

Question 2

NPV def

Answer 2

Present value of cash flows minus initial investment

Question 3

opportunity cost of capital def

Answer 3

expected rate of return given up by investing in a project

Question 4

NPV formula

Answer 4

NPV = PV - required investment
NPV = C0 + C1/(1+r) + C2/(1+r)^2+….+ Ct/(1+r)^t

works for projects of any duration

Question 5

critical problems in NPV exercices

Answer 5

• determine the amount and timing of the cahs flows
• the appropriate discount rate

Question 6

NPV rule

Answer 6

• managers increase shareholders’ wealth by accepting all projects that are worth more than they cost => accept all projects with positive NPV

for single project:
- do it iff its NPV is positive

for many independent projects:
- do it for all positive NPV projects

for mutually exclusive projects:
- choose the one with the highest NPV

Question 7

Other investment criteria than NPV

Answer 7

• most firms use the NPV criterion (it will maximize the value of a firm’s shares)
• other criteria are used because: some give wrong answers, some require work to get

2most common : payback, discounted payback, Internal Rate of Return, profitability index

Question 8

payback period def

Answer 8

time until cash flows recover the initial investment of the project

Question 9

payback rule

Answer 9

accept a project if its payback period is less than the specified cutoff period

Question 10

payback method drawbacks

Answer 10

• does not consider any cash flows that arrive after the payback period
• gives equal weight to all cash flows arriving before the cutoff period even though distant cash flows are more valuable
• difficult to find the optimal cutoff period

Question 11

discount payback period def

Answer 11

discounted payback is the time period it takes for the discounted cash flows generated by the project to cover the initial investment in the project

Question 12

advantages and drawbacks of discounted payback method

Answer 12

advantage:
- helps to find the cutoff

drawbacks:
- ignores all cashflows occurring after the arbitrary cutoff
- easily misrank competing projects

Question 13

internal rate of return (IRR) def

Answer 13

IRR is the discount rate at which the NPV of the project equals 0

Question 14

IRR rule

Answer 14

accept a project if it offers a rate of return higher than the opportunity cost of capital

Question 15

how to find the IRR

Answer 15

solve for r : NPV = [C1/(1+r)] - C0
with NPV = 0

or use a graph method: the point where NPV line crosses the x-axis is the IRR

Question 16

project rate of return and NPV

Answer 16

• the rate of return is the discount rate that will give a project an NPV = 0.
• if opportunity cost of capital < project rate of return => NPV is positive
• if opportunity cost of capital > project rate of return => NPV is negative

Question 17

finding the rate of return on long-lived projects

Answer 17

rate of return = profit/investment = (C1 - C0)/C0

Question 18

drawbacks of IRR

Answer 18

• does not consider if the money is lended or borrowed: pick the project where you earn more than the opportunity cost of capital
• mutltiple rate of returns: if projects have more than one discount rate it doesn’t work
• mutually exclusive projects it doesnt consider the size only the rate: choose the one with the highest NPV

Question 19

three challenges of choosing between mutually exclusive projects

Answer 19

• investment timing decision
• choice between long-lived vs short-lived equipment
• replacement problem

Question 20

investment timing decision def

Answer 20

sometimes you can defer an investment and select a time that is more idea at which to make the investment decision

• the decision rule is to choose the investment date that results in the highest NPV today

Question 21

long- lived vs short-lived equipment

Answer 21

for comparing assets with different lives we need to compare their Equivalent Annual Costs

The equivalent annual cost (EAC) is the cost per period with the same OV as the cost of the machine

• if mutually exclusive projects have unequal lives then you should calculate the equivalent annual costs of the projects

Question 22

replacement problem

Answer 22

when should existing machinery be replaced ?

compare the cost of operating the old asset with the equivalent annual cost of the new

Question 23

soft rationing def

Answer 23

limits imposed by senior management

Question 24

capital rationing def

Answer 24

limit set on the amount of funds available for investment

with capital rationing need to select a group of projects which:
- is within the company’s resources and
- gives the highest NPV

Question 24

Profitability index def

Answer 24

pick projects that give the highest NPV per dollar of investment

PI = NPV/ initial investment

Question 24

hard rationing def

Answer 24

limits imposed by the unavailability of funds in the capital markets