Chapter 9 Net present value and other investment criteria

Question 1

is all about trying to determine
whether a proposed investment or project will be
worth more, once it is in place, than it costs.

Answer 1

Capital budgeting

Question 2

The difference between an
investment’s market value and its cost

Answer 2

Net Present Value

Question 3

It is a measure of how much value is created or added
today by undertaking an investment.
* It is an estimate

Answer 3

Net Present Value

Question 4

is a search for
investments with positive net present values

Answer 4

The capital budgeting process

Question 5

The process
of valuing an investment by discounting its future cash
flows

Answer 5

Discounted Cash Flow (DCF) Valuation

Question 6

An investment should be
accepted if the net present value is positive and rejected
if it is negative.

Answer 6

Net Present Value Rule

Question 7

is one way of assessing the profitability of a
proposed investment

Answer 7

NPV

Question 8

is the length of time it takes to recover
our initial investment

Answer 8

payback

Question 9

The amount of time required for
an investment to generate cash flows sufficient to
recover its initial cost

Answer 9

Payback Period

Question 10

Based on the payback period
rule, an investment is acceptable if its calculated
payback period is less than some prespecified
number of years.

Answer 10

Payback Period Rule
(May include a fractional year, which requires a
portion of that year’s cash flow to recover the initial
cost)

Question 11

• No discounting involved, so the time value of money is
  completely ignored
• Calculated by simply adding up the future cash flows
• Fails to consider any risk differences between projects
• Calculated the same way for very risky and very safe projects
• No objective basis for choosing a particular number for the
  cutoff period
• Chosen arbitrarily
• Generally, will tend to bias
  financial managers toward shorter-term investments
• is often used by large and sophisticated companies
  when they are making relatively minor decisions

Answer 11

analysis of the payback period rule

Question 12

Two primary shortcomings of the payback period rule

Answer 12

1. By ignoring the time value of money, may be led to accept
   investments that actually have negative NPV
2. By ignoring cash flows beyond the cutoff, may be led to reject profitable longer-term investments

Question 13

3 Reasons why large companies use the payback period rule for minor decisions

Answer 13

1. Simplicity: many decisions do not warrant detailed
   analysis because the cost of that analysis would exceed
   the possible loss from a mistake
2. Bias towards liquidity: bias towards short-term projects
   tends to favor investments that free up cash for other
   uses quickly
3. Adjusts for the riskiness of later cash flows: cash flows
   that are expected to occur later in a project’s life are
   probably more uncertain

Question 14

The length of time required for an investment’s discounted cash flows to equal its initial cost

Answer 14

Discounted Payback Period

Question 15

an investment is
acceptable if its discounted payback is less than
some prespecified number of years.

Answer 15

Discounted Payback Rule

Question 16

• Not especially simple to calculate
• Cutoff is arbitrarily set
• Cash flows beyond the cutoff are ignored

Answer 16

Drawbacks of the discounted payback

Question 17

If a financial manager needs to assess the time it
will take to recover the investment required by a
project
Which is better to use the discounted payback or ordinary payback?

Answer 17

the discount payback because it considers time value
(recognizes that we could have invested the money elsewhere and earned a return on it)

Question 18

The discount rate that
makes the NPV of an investment zero

Answer 18

Internal Rate of Return (IRR)
(t\it depends only on the cash flows of a particular investment, not on rates offered elsewhere)

Question 19

An investment is acceptable if the IRR
exceeds the required return. It should be rejected
otherwise

Answer 19

IRR Rule

Question 20

is the required return that
results in a zero NPV when it is used as the
discount rate.

Answer 20

The IRR on an investment

Question 21

The IRR and NPV rules always lead to identical
decisions, so long as two very important conditions
are met

Answer 21

1. The projects cash flows must be conventional,
   meaning that the first cash flow is negative, and all the
   rest are positive.
2. The project must be independent, meaning that the
   decision to accept or reject this project does not affect the
   decision to accept or reject any other.

Question 22

The possibility that more than
one discount rate will make the NPV of an investment
zero

Answer 22

Multiple Rates of Return

Question 23

A situation in
which taking one investment prevents the taking of
another

Answer 23

Mutually Exclusive Investment Decision

Question 24

is project size factored in with IRR

Answer 24

no

Question 25

the discount rate that makes the
NPVs of two projects equal

Answer 25

Crossover Rate

Question 26

The basic idea is to modify the cash flows first and
then calculate the IRR using the modified cash flows

Answer 26

The Modified Internal Rate of Return (MIRR)

Question 27

• Negative cash flows are discounted back to the present
• Positive cash flows are compounded to the end of the
  project

Answer 27

The Combination Approach

Question 28

is only an estimate

Answer 28

NPV