Corporate Finance & Portfolio Management

Question 1

What is the acceptance rule for NPV?

Answer 1

Invest if NPV > 0

Do not invest if NPV

Question 2

What is the Internal Rate of Return (IRR) and how is it calculated?

Answer 2

IRR is the discount rate that makes the PV of the future after-tax cash flows equal to the investment outlay.

CF1/(1+IRR)^1 + CF2/(1+IRR)^2 + … + CFn/(1+IRR)^n - Outlay = 0

Question 3

What is the IRR decision rule?

Answer 3

Invest if IRR > r

Do not invest if IRR

Question 4

Payback Period & Discounted Payback Period

Answer 4

Payback period is the # of years required to recover the original investment in a project. It is based on Cash Flows.

Discounted Payback Period is the # of years it takes the cumulative discounted cash flows from a project to equal the original investment.

Question 5

Average Accounting Rate of Return

Answer 5

AAR = Avg. Net Income / Avg. Book Value

Question 6

Profitability Index

Answer 6

The PV of a project’s future cash flows divided by the initial investment.

PI = PV of future cash flows / initial investment = 1 + NPV / Initial Investment

Question 7

The Profitability Index Rule

Answer 7

Invest if: NPV = positive, PI > 1.0

Do not invest if: NPV = negative, PI

Question 8

What is Net Present Value (NPV) and how is it calculated?

Answer 8

NPV is the PV of the future after-tax cash flows minus the investment outlay.

NPV = CF1/(1+r)^1 + CF2/(1+r)^2 + … + CFn/(1+r)^n