Chapter 9 Flashcards
What is the NPV method?
Determining whether the difference between an assets cost and NPV is greater than 0.
What is the Payback Rule?
The length of time that is required to return the initial investment value.
What are the flaws of the payback rule?
I.) it ignores future value through not discounting
II.) It ignores risk
III.) the cutoff period is hard to find as it is objective.
IV.) It is biased towards a Short-Term orientation
What are the benefits of the Payback rule?
I.) It is good at examining short-term investments
II.) It biases liquidity
III.) Ignores long term cash flows which are often more uncertain
What is a flaw of NPV?
It is only an estimate.
How do you calculate the AAR?
Net Income/Average Book Value
NPV and IRR lead to the same decision if….
Cash flows are conventional and the project is independent.
Which method calculates the break even period in an economic sense?
Discounted payback rule
Why is the Discounted payback method not often used in practice?
It requires an arbitrary cutoff point and is not simpler than NPV
What are the flaws when using the AAR method?
I.) It focuses on net income and BV rather than OCF
II.) There is an arbitrary cutoff
III.) Does not discount.
What are the benefits to using AAR?
I.) Easy to calculate
II.) Information is readily available
If a company is ‘hard rationing’ what does this mean?
It means the company is unable to purchase an investment with a positive NPV due to an lack of funds.
What does it mean if a company is soft rationing?
It means the company is unable to purchase an investment with a positive NPV due to it not being within their budget.
If there is a PI ratio is 1.5 what does this mean?
It means for every dollar invested, we earn $0.50
