lecture 4: chapter 7: NPV, IRR Flashcards
capital budgeting
the decision-making process for accepting or rejecting projects
true or false
The value of the firm rises by the NPV of the project
true
value additivity of a firm
the value of the firm is merely the sum of the values of the different projects, divisions, or other entities within the firm
the contribution of any project to a firm’s value is simply the NPV of the project
the discount rate on a risky project
the return that one can expect to earn on a financial asset of comparable risk
often referred to as an opportunity cost
–> corporate investment in the project takes away the shareholder’s opportunity to invest the dividend in a financial asset
NPV’s three attributes
- NPV uses cash flows
- NPV uses all the cash flows of the project (unlike other methods such as the payback period or the discounted payback period)
- NPV discounts the cash flows properly (unlike other methods such as the payback period)
why should earnings not be used in capital budgeting?
because they do not represent cash
they are an artificial construct useful to accountants
the payback period method
you see in how much time you recover the initial investment
we disregard the Pis of cashflows
we use a cut off time, in which projects that go over it are refused
Problems with the Payback Method
Problem 1: Timing of Cash Flows within the Payback Period
–> this shows that the payback method is inferior to NPV because, as we pointed out earlier, the NPV approach discounts the cash flows properly
Problem 2: Payments after the Payback Period
–> This flaw is not present with the NPV approach because, as we pointed out earlier, the NPV approach uses all the cash flows of the project
–> the payback method forces managers to have an artificially short-term orientation, which may lead to decisions not in the shareholders’ best interests
Problem 3: Arbitrary Standard for Payback Period
–>
when can we make decisions from the payback method without stressing?
for small decisions
Why would upper management condone or even encourage the payback method to its employees?
it is easy to make decisions using payback
desirable features of the payback method for managerial control
- we can evaluate the manager’s decision-making ability
–> Under the NPV method, a long time may pass before we can decide whether or not a decision was correct
- good for firms with good investment opportunities but no available cash
- a number of executives have told us that for the overwhelming majority of real-world projects, both payback and NPV lead to the same decision
the discounted payback period rule
same as payback period method, but cashflows are discounted
naturally, the period to payback the initial outflow is longer than the normal payback period
the average accounting return (AAR)
the average project earnings after taxes and depreciation, divided by the average book value of the investment during its life
these to find the AAR
Step 1: Determine the average net income
Step 2: Determine the average investment
Step 3: Determine the AAR
–> step 1 / step 2
what is wrong with the AAR method?
- It uses net income and book value of the investment, both of which come from the accounting books
–> Accounting numbers are somewhat arbitrary
–> affected by the accountant’s judgment.
–> Conversely, the NPV method uses cash flows (not affected by accountant’s judgment)
- takes no account of timing
–> the NPV approach discounts properly
- the AAR method offers no guidance on what the right targeted rate of return should be
