Chapter 9

Question 1

Net present value

Answer 1

A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.

Question 2

Finding NPV

Answer 2

1. Estimate the expected future cash flows
2. Estimate the return on investment with this level of risk
3. Calculate the present value of cash flows and subtract the value of the (initial) investment.
   If NPV is positive, accept the investment

Question 3

(Simple) payback period

Answer 3

Estimate the cash flows, subtract the future cash flows from the initial cost until the initial investment has been recovered.

Accept if the payback period is less than some pre-set limit.

Question 4

Advantages and disadvantages of payback

Answer 4

Advantages: easy to understand; adjusts for uncertainty of later cash flows; based toward liquidity; popular for quick reviews.

Disadvantages: ignores the time value of money; requires a subjective, arbitrary cutoff point; ignores cash flows beyond the cutoff date; biased against long-term projects such as research and development and new projects; based on this it can also cause problems when determining the order and in the case of mutually exclusive investments.

Question 5

Discounted payback period

Answer 5

1. estimate cash flows
2. subtract the present value of future cash flows from the initial cost until the initial investment is recovered
3. compare to a selected cut-off rate
4. in case of more investments: which one pays back sooner

Accept the project if it pays back on a discounted basis within the specified time.

Question 6

Advantages and disadvantages of discounted payback

Answer 6

Advantages:
* Includes time value of money
* Easy to understand
* Does not accept negative
estimated NPV investments
when all future cash flows are
positive
* Biased towards liquidity

Disadvantages
* No longer so simple and understandable
* May reject positive NPV investments
* Requires an arbitrary cutoff point
* Ignores cash flows beyond the cutoff point
* Biased against long-term projects, such as R&D and new products

Question 7

Average accounting return

Answer 7

Average net income/average book value

Accept the project if the AAR is greater than pre-set rate.

Question 8

Advantages and disadvantages of AAR

Answer 8

Advantages
▪ Easy to calculate
▪ Needed information will
usually be available

Disadvantages
▪ Not a true rate of return; time value of money is ignored
▪ Uses an arbitrary benchmark cutoff rate
▪ Based on accounting net income and book values, not cash flows and market values

Question 9

Internal rate of return

Answer 9

• This is the most important alternative to NPV.
• It is often used in practice and is intuitively appealing.
• It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere.
• However, using as decision making tool it is not better than NPV

Question 10

Conflicts between NPV and IRR

Answer 10

Generally give the same decision. If there’s a conflict you should choose NPV.