Chapter 9 - Net Present Value and Other Investment Criteria Flashcards
What is another name for capital budgeting?
Strategic asset allocation, since there are a lot of strategic issues whose answers involve operational changes
What is the general idea of capital budgeting?
Trying to determine whether a proposed investment or project will be worth more than it costs once it is in place
What are the three criteria when evaluating each method and determining which to use?
- 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 the Net Present Value (NPV) of an investment?
The difference between an investment’s market value and its cost
What is the discounted cash flow (DCF) valuation?
Estimate the future cash flows, and estimate the PV of those cash flows.
Afterward, we estimate NPV as the difference between the PV of the future cash flows and the cost of investment
What is the payback?
The length of time it takes to recover our initial investment
What are the biggest issues with the payback period rule?
Coming up with the right cutoff period
We just add the future cash flows without adjusting for the time value of money so it is ignored
Dont consider profitability post payback
Who uses the payback rule?
Small businesses whose managers lack financial skills.
Also used by large and sophisticated companies when making relatively small decisions
What are the two benefits of the payback rule?
Biased towards short term projects meaning towards liquidity (good for small businesses)
Future estimations of income are uncertain so if a model for a 10 year stretch is better than that of a 3 year stretch we are not guaranteed that income in the future
What is the discounted payback period?
Length of time until the sum of the discounted cash flows equals the initial investment
*Time to break even in an economic or financial sense
What are the advantages of the discounted payback period rule?
Advantages:
1. Includes time value of money
2. Easy to understand
3. Does not accept negative estimated NPV investments
4. Biased toward liquidity
What are some of the disadvantages of the discounted payback period rule?
- May reject positive NPV investments
- Requires an arbitrary cutoff point
- Ignores cash flows beyond the cutoff date
- Biased against long-term projects, such as research and development, and new projects
What is the Average Accounting Return (AAR)?
Some measure of average accounting profit / Some measure of average accounting value
AAR = Average net income / Average book value
What are some advantages of AAR?
- Easy to calculate
- Required information is usually available
What are some disadvantages of AAR?
- Not a true rate of return
- Uses an arbitrary benchmark cutoff rate
- Based on accounting values, not cash flows or market values
What is the most important alternative to NPV (Net Present Value)?
The internal rate of return (IRR)
What is the IRR rule?
An investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise
How are a bond’s YTM related to the concept of an IRR?
The YTM of a bond is that bond’s IRR
How is the IRR related to the NPV?
The IRR on an investment is the return that results in a zero NPV when it is used as the discount rate
Generally, what is the only way to find the IRR?
By trial and error through hand methods or by calculator
What is the IRR sometimes called?
The discounted cash flow or DCF return.
What is the net present value profile?
A line on a graph we get from putting discount rates on the x-axis and different NPVs on the y-axis
What are the two conditions for IRR and NPV rules leading to identical decisions?
- The project’s cash flows must be conventional meaning that the first cash flow (initial investment) is negative and all the rest are positive.
- The project must be independent, meaning the decision to accept or reject this project does not affect the decision to accept or reject any other.
What issue arises with IRR when cash flows are not conventional?
Multiple rates of return problem, more than one discount rate makes the NPV of an investment zero
When do non-conventional cash flows occur?
When a project has an outlay (negative cash flow) at the end or intermediate part of the project as well as the beginning
What are mutually exclusive investment decisions?
The potential problem in using the IRR method is where the acceptance of one project excludes that of another
When considering mutually exclusive investment decisions what issue arises when considering the IRR over the NPV?
Sometimes the IRR might be higher for option B however at lower rates the NPV for option B could be higher across a wider range.
So the actual final answer would depend on the rates and the NPV decision as that is what actually measures the value for the investment
Essentially don’t rank them on their returns, use NPV
What is the crossover point?
The point at which one investment becomes more attractive than another
When the NPVs of the two projects are equal
NPV(B-A) = 0
Essentially take all the values in B and subtract all of the values in A and equal NPV to 0
Which is more popular in practice IRR or NPV and why?
IRR is more popular as people prefer to talk about rates of return rather than dollar values
What are some advantages of IRR?
- Closely related to NPV, generally leading to identical decisions
- Easy to understand and communicate
What are some disadvantages of IRR?
- May result in multiple answers or no answers with non-conventional cash flows
- May lead to incorrect decisions in comparisons of mutually exclusive investments
What is the Profitability Index (PI)?
The present value of an investment’s future cash flows divided by its initial cost; also, the benefit/cost ratio
When NPV is positive what must PI be?
Larger than 1
When is PI usually used?
In government and non-profit situations
Also more of a concern for smaller companies
What are some advantages of PI?
- Closely related to NPV
- Easy to understand and communicate
- May be useful when available investment funds are limited
What are some disadvantages of PI?
- May lead to incorrect decisions in comparisons of mutually exclusive investments
What percentage of companies use NPV and IRR?
1/3 NPV
2/3 IRR
Which firms are more likely to use NPV?
Those that can estimate cash flows better since that’s what the ratio is based upon
This varies by industry
Energy industry yippy NPV
Entertainment industry boooo NPV
What is Capital Rationing?
The situation that exists if a firm has positive NPV projects but cannot find the necessary financing
What is Soft Rationing?
Lack of capital brought upon by a limited allocation of finance for capital budgeting to a specific unit of that business.
Not as bad because realistically more capital can be raised if approved
What does chronic soft rationing mean?
We are constantly passing up positive NPV investments which is no bueno
What is hard rationing?
A business cannot raise capital for a project under any circumstances, “they’re broke”
What is the only assumption we can logically make during a hard rationing period?
Due to the breakdown of the DCF analysis, we can only assume that the required rates of return are too high
When does hard rationing occur?
When a company experiences financial distress
Why do we say that our standard discounted cash flow analysis is static?
A standard discounted cash flow (DCF) analysis is often referred to as static because it typically relies on a fixed set of assumptions and conditions that do not change over time. Here are the key reasons why it’s considered static:
Do we use discounted cash flow values when calculating NPV?
Yes
