Finance: Ch5 NPV and other investment criteria

Question 1

What is the payback period, and why should it not be used as a rule for accepting projects?

Answer 1

The payback period is the number of years it takes for the cumulative cash flow to equal the initial investment. While it’s fine as a descriptive statistic, it should not be used as a decision-making rule because it ignores important factors like cash flows after the cutoff period and the time value of money.

Question 2

What is the accounting rate of return (or book rate of return) and how is it calculated?

Answer 2

The accounting rate of return (or book rate of return) is a profitability measure calculated by dividing a project’s expected average profits by its average assets. It helps evaluate the profitability of a project.

Question 3

How is the return calculated for projects with cash flows over multiple periods?

Answer 3

The return is calculated by finding the discount rate that results in a zero Net Present Value (NPV). This rate is called the Internal Rate of Return (IRR).

Question 4

What is the potential issue with using the Internal Rate of Return (IRR)?

Answer 4

Although IRR is a commonly used and handy measure in finance, it can be easily misused if not understood or applied properly. It’s important to calculate and interpret it carefully.