Chapter 9 Net present value and other investment criteria Flashcards
is all about trying to determine
whether a proposed investment or project will be
worth more, once it is in place, than it costs.
Capital budgeting
The difference between an
investment’s market value and its cost
Net Present Value
It is a measure of how much value is created or added
today by undertaking an investment.
* It is an estimate
Net Present Value
is a search for
investments with positive net present values
The capital budgeting process
The process
of valuing an investment by discounting its future cash
flows
Discounted Cash Flow (DCF) Valuation
An investment should be
accepted if the net present value is positive and rejected
if it is negative.
Net Present Value Rule
is one way of assessing the profitability of a
proposed investment
NPV
is the length of time it takes to recover
our initial investment
payback
The amount of time required for
an investment to generate cash flows sufficient to
recover its initial cost
Payback Period
Based on the payback period
rule, an investment is acceptable if its calculated
payback period is less than some prespecified
number of years.
Payback Period Rule
(May include a fractional year, which requires a
portion of that year’s cash flow to recover the initial
cost)
- 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
analysis of the payback period rule
Two primary shortcomings of the payback period rule
- By ignoring the time value of money, may be led to accept
investments that actually have negative NPV - By ignoring cash flows beyond the cutoff, may be led to reject profitable longer-term investments
3 Reasons why large companies use the payback period rule for minor decisions
- Simplicity: many decisions do not warrant detailed
analysis because the cost of that analysis would exceed
the possible loss from a mistake - Bias towards liquidity: bias towards short-term projects
tends to favor investments that free up cash for other
uses quickly - 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
The length of time required for an investment’s discounted cash flows to equal its initial cost
Discounted Payback Period
an investment is
acceptable if its discounted payback is less than
some prespecified number of years.
Discounted Payback Rule
- Not especially simple to calculate
- Cutoff is arbitrarily set
- Cash flows beyond the cutoff are ignored
Drawbacks of the discounted payback
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?
the discount payback because it considers time value
(recognizes that we could have invested the money elsewhere and earned a return on it)
The discount rate that
makes the NPV of an investment zero
Internal Rate of Return (IRR)
(t\it depends only on the cash flows of a particular investment, not on rates offered elsewhere)
An investment is acceptable if the IRR
exceeds the required return. It should be rejected
otherwise
IRR Rule
is the required return that
results in a zero NPV when it is used as the
discount rate.
The IRR on an investment
The IRR and NPV rules always lead to identical
decisions, so long as two very important conditions
are met
- The projects cash flows must be conventional,
meaning that the first cash flow is negative, and all the
rest are positive. - 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.
The possibility that more than
one discount rate will make the NPV of an investment
zero
Multiple Rates of Return
A situation in
which taking one investment prevents the taking of
another
Mutually Exclusive Investment Decision
is project size factored in with IRR
no
the discount rate that makes the
NPVs of two projects equal
Crossover Rate
The basic idea is to modify the cash flows first and
then calculate the IRR using the modified cash flows
The Modified Internal Rate of Return (MIRR)
- Negative cash flows are discounted back to the present
- Positive cash flows are compounded to the end of the
project
The Combination Approach
is only an estimate
NPV
