Lecture 4

Question 1

Book rate of return =

Answer 1

Book income / book assets

Question 2

Payback period

Answer 2

Number of years before cumulative cash flows equal initial outlay

Question 3

Pay back rule

Answer 3

Only accept projects that pay back with in desired time frame

Question 4

Payback period =

Answer 4

NO years of full recovery

+

uncovered cost / cash flow of last year before full payback

Question 5

What does the payback rule ignore

Answer 5

The time value of money

Question 6

Net present value of investment

Answer 6

Difference. Between the present value of its benefits and the required investment

Question 7

NPV 0 =

Answer 7

C 0 + sum of C t / (1+r)^t

Question 8

NPV rule

Answer 8

Managers increase shareholders wealth by accepting all projects with positive NPV

Question 9

Mutually exclusive projects

Answer 9

Taking one. Investments makes the other redundant bc they both serve same purpose

Question 10

What should you do when choosing between mutually exclusive projects

Answer 10

Choose on with highest NPV

Question 11

IRR of a project ….

Answer 11

Is the discount rate that makes the projects NPV = 0

Question 12

Opportunity cost of capital

Answer 12

Expected rate of return given up by investment in another project

Question 13

IRR rule

Answer 13

Managers increase shareholders wealth by accepting all. Projects with IRR that is higher than the opportunity cost of capital (hurdle rate)

Question 14

Calculating IRR

Answer 14

0= C 0+ sum of Ct/ (1+ IRR)^t

Trial and error

Question 15

What do you do in the case of borrowing

Answer 15

Accept if IRR< the opportunity cost of capital

Question 16

What happens to IRR when there are cash flows with multiple signs

Answer 16

More than 1 IRR

Question 17

The more serious the capital rationing…

Answer 17

The more likely IRR will be used

Question 18

Business had limited cash

What rule do they use

Answer 18

Then they’ll use IRR decision rule

Question 19

If business has substantial funds

What rule do they use

Answer 19

NPV decision rule

Question 20

What does profitability index do

Answer 20

Different scale investment comparable

Question 21

Profitability index =

Answer 21

NPV / initial investment

Question 22

Capital constraints causes you to do what

Answer 22

Pick combination of investments that yield highest NPV

Question 23

What does high cash flow earlier mean

Answer 23

Hurt less by discounting

Question 24

What does NPV assume

Answer 24

Cash flow gets reinvested at discount rate

Question 25

what does IRR assume

Answer 25

Cash flow gets reinvested at IRR rate q

Question 26

What does IRR when it is high

Answer 26

IRR will overstate the true return of the project