Chapter 8: NPV and other investment criteria Flashcards
What is the net present value of an investment, and how do you calculate it? (LO8-1)
The net present value of a project measures the difference between its value and cost. NPV is, therefore, the amount that the project will add to shareholder wealth. A company maximizes shareholder wealth by accepting all projects that have a positive NPV.
How is the internal rate of return of a project calculated, and what must one look out for when using the internal rate of return rule? (LO8-2)
Instead of asking whether a project has a positive NPV, many businesses prefer to ask whether it offers a higher return than shareholders could expect to get by investing in the capital market. Return is usually defined as the discount rate that would result in a zero NPV. This is known as the internal rate of return, or IRR. The project is attractive if the IRR exceeds the opportunity cost of capital.
There are some pitfalls in using the internal rate of return rule. Be careful about using the IRR when (1) you need to choose between two mutually exclusive projects, (2) there is more than one change in the sign of the cash flows, or (3) the early cash flows are positive.
How is the profitability index calculated, and how can it be used to choose between projects when funds are limited? (LO8-3)
If there is a shortage of capital, companies need to choose projects that offer the highest net present value per dollar of investment. This measure is known as the profitability index.
Why doesn’t the payback rule always make shareholders better off? (LO8-4)
The net present value rule and the rate of return rule both properly reflect the time value of money. But companies sometimes use rules of thumb to judge projects. One is the payback rule, which states that a project is acceptable if you get your money back within a specified period. The payback rule takes no account of any cash flows that arrive after the payback period and fails to discount cash flows within the payback period.
How can the net present value rule be used to analyze three common problems that involve competing projects: when to postpone an investment expenditure, how to choose between projects with unequal lives, and when to replace equipment? (LO8-5)
Sometimes, a project may have a positive NPV if undertaken today but an even higher NPV if the investment is delayed. Choose between these alternatives by comparing their NPVs today.
When you have to choose between projects with different lives, you should put them on an equal footing by comparing the equivalent annual annuity of the two projects. When you are considering whether to replace an aging machine with a new one, you should com- pare the annual cost of operating the old one with the equivalent annual annuity of the new one.
