Chapter 9 Flashcards
What do we consider when evaluating decision criteria?
Does the decision rule adjust for the time value of money?
Does the decision rule adjust for risk?
Does the decision rule provide information on whether we are creating value for the firm?
What is NPV?
Net Present Value is the difference between the value of a project and its cost
What steps should one take to find the NPV created from undertaking an investment?
- Estimate expected future cash flows
- Estimate required return for projects of the risk level
- Find PV of the cash flows and subtract initial investment
What is the Payback Rule?
How long it takes to get the initial cost back in a nominal sense
What are the advantages and disadvantages of Payback?
Advantages: Easy to understand and biased towards liquidity
Disadvantages: Ignores time value of money and cash flows beyond the cutoff date
What is the discounted Payback Period?
More sophisticated payback calculation on a discounted basis.
What are the advantages and disadvantages of Discounted Payback?
Advantages: Includes time value of money and easy to understand
Disadvantages: Requires an arbitrary cutoff point and ignores cash flows beyond the cutoff date
What is the Internal Rate of Return?
The rate that makes the NPV equal zero. It is calculated using trial and error.
What are the advantages and disadvantages of IRR?
Advantages: Knowing a return is intuitively appealing and a simple way to communicate the value of a project.
Disadvantages: NPV and IRR generally give the same decision on a project.
When is there more than one IRR?
When the cash flows change sign more than once.
when is IRR unreliable?
in non-conventional cash flows and mutually exclusive projects
What is the profitability index?
Measures the benefit per unit cost, based on the time value of money.
What are the advantages and disadvantages of Profitability Index?
Advantages: Closely related to NPV and easy to understand and communicate
Disadvantages: May lead to incorrect decisions in comparisons of mutually exclusive investments
What are the most common primary and secondary investment criteria?
Primary: NPV and IRR
Second: Payback/discounted payback
