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Business Finance > Module 8: Investment Criteria > Flashcards

Module 8: Investment Criteria Flashcards

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1
Q

measures that companies and individuals can use for evaluating projects that cost money and produce future cash flows

A

investment criteria measures

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2
Q

a measure of how much value is created or added today by undertaking an investment (the difference between the investment’s market value and its cost).

A

Net Present Value (NPV)

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3
Q

T or F: NPV is the gold standard, capital budgeting measure.

A

True

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4
Q

How do you solve for NPV (2 steps)?

A
  1. Estimate future cash flows
  2. Calculate the PV of those cash flows
  3. Subtract initial cost
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5
Q

The NPV Rule: An investment should be accepted if the NPV is _______ and ________ if the NPV is negative. When deciding between investments, pick the subset that _________ total NPV (pick the _______ NPV).

A

positive; rejected; maximizes; largest

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6
Q

What is the advantage of NPV?
What is the disadvantage of NPV?

A
  • Always results in the correct decision when inputs are correct.
  • Needs the appropriate discount rate. (there will always be uncertainty about what the correct discount rate is, so there will always be some uncertainty about whether this really is a positive or negative NPV project)
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7
Q

What is the next most important/commonly used measure behind NPV?

A

Internal Rate of Return (IRR)

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8
Q

the discount rate that makes the net present value of a project equal to zero.

A

internal rate of return

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9
Q

If the IRR is the appropriate discount rate, we will be _________ about accepting or rejecting the project.

A

indifferent
(ex: $100 for $100 trade; no better or worse off than if we didn’t make that trade)

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10
Q

How do you solve for IRR (2 steps)?

A
  1. Set NPV = 0
  2. Solve for r
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11
Q

T or F: Calculating IRR is identical to calculating the yield to maturity of a bond. (This cannot be done algebraically most of the time; need to use calculator).

A

True

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12
Q

The IRR Rule: An investment is acceptable if the IRR ________ the required ________ (the _______ rate). It should be rejected otherwise.

A
  • exceeds; return; discount
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13
Q

What are the 2 advantages of IRR?

A
  1. Closely related to NPV, but doesn’t require a discount rate.
  2. Easy to understand and communicate
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14
Q

What are the 3 disadvantages of IRR?

A
  1. If cash flows are nonconventional there may be multiple IRRs.
  2. If cash flows are nonconventional, IRR rule may result in incorrect decision.
  3. When deciding between investments, IRR may not result in the correct decision. (since IRR doesn’t account for scale)
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15
Q

all costs at the beginning (could be more than one year); everything else is positive) → (for ex: our IRR example has the -2,000 at the beginning and then everything else is positive (the year 1 and 2 “1,500’s” are positive)

A

conventional cash flows

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16
Q

either when our costs are not up front or when we go back and forth (negative to positive to negative…)

A

nonconventional cash flows

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17
Q

T or F: When using IRR to evaluate which project you should choose between two mutually exclusive projects, you should always choose the project that provides the higher return (higher IRR).

A

False; may always have the higher IRR, but doesn’t always have the higher NPV.

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18
Q

To calculate the crossover rate when choosing between two investment projects, how do you do this? (3 steps)

What does this tell us?

A
  1. Subtract Project A cash flow in each year - Project B cash flow. (get the difference between Project A and Project B cash flow for each cash flow provided)
  2. Plug these cash flow results into CF keys
  3. Compute IRR

Tells us that that certain IRR we compute is when the crossover is of Project A and Project B, so like when it switches which project would be a better option.

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19
Q

a calculation of the IRR on a modified set of cash flows; is an attempt to fix the IRR disadvantage that if cash flows are nonconventional, IRR rule may result in incorrect decision.

A

Modified Internal Rate of Return

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20
Q

What are the 3 ways you can modify the cash flows to solve for MIRR?

A
  • 1st way: discount all the cash outflows to time zero (take all the negative cash flows occurring in the future and discount them back to today to combine them with our initial costs) (getting PVs)
  • 2nd way: compound all the cash inflows to the end of the project (getting FVs)
  • 3rd way: combine both procedures (discount all cash outflows to beginning, grow all cash inflows to the end)

Then, you just compute IRR

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21
Q

For the combined way to solve for MIRR, you discount cash (inflows/outflows) and grow cash (inflows/outflows)

A
  • outflows
  • inflows
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22
Q

We should use MIRR when we have ____________ cash flows.

A

nonconventional

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23
Q

MIRR Rule:
An investment is acceptable if the MIRR _________ the required _______. It should be rejected otherwise.

A

exceeds; return

24
Q

Two advantages to MIRR:
1. Closely related to _______.
2. No longer possible to get _________ _______.

A
  1. NPV
  2. Multiple Rates
25
Q

Disadvantages of MIRR:
1. _________ ways to calculate it.
2. When deciding between __________, MIRR may not result in the correct decision (just like IRR).
3. ______ is just as easy to calculate.

A
  1. Multiple
  2. Investments
  3. NPV (may as well just use NPV for a better estimate)
26
Q

T or F: Out of the 3 ways to calculate MIRR, using the combined procedure is better than the others.

A

False; no one procedure is better than the other.

27
Q

T or F: The Profitability Index is much simpler to calculate than MIRR because there is only one way to calculate it.

A

True

28
Q

the present value of an investment’s future cash flows divided by the absolute value of its initial cost. Also called a benefit-cost ratio.

A

Profitability Index (PI)

29
Q

What is the NPV formula?

What is the Profitability Index Formula?

A
  • NPV: PV of future cash flows - Cost
  • PI: PV of future cash flows / [Cost]

^ absolute value bars around the cost for PI

30
Q

What are the two steps in solving for Profitability Index?

A
  1. Discount all future cash flows to time zero
  2. Divide that sum by the absolute value of the initial cost
31
Q

_______ NPV projects will have a PI greater than 1 and ______ NPV projects will have a PI less than 1.

A

Positive; negative

(So if PI is greater than 1, we should accept the project)

32
Q

The PI Rule:
Only accept projects with a PI greater than ______, and invest in projects with the _________ PI’s first.

A

1; largest

33
Q

Advantages of Profitability Index (PI):
1. Closely related to ______.
2. Can be useful when _______ _______ are limited.

A
  1. NPV
  2. investment funds
34
Q

Disadvantage of Profitability Index (PI):
1. Not reliable if investments are ______ _________.

A

mutually exclusive

35
Q

If projects are mutually exclusive, to figure out which project we should choose, we should calculate (PI/NPV).

If projects are repeatable (multiple projects), to figure out which project we should choose, we should calculate (PI/NPV).

A
  • NPV
  • PI
36
Q

PI is useful when we’ve got fixed _______ and ________ projects.

A

budgets; multiple

(We still would want to maximize our NPV with repeatable projects, but which project that will maximize NPV depends on what our budgetary constraints are)

37
Q

the length of time it takes to recover the initial investment.

A

Payback Period

38
Q

When calculating the Payback Period, we should assume cash flows are received ________ throughout the year.
Then, we should calculate the number of _______ it will take for future cash flows to match the _______ cash (inflow/outflow)

A

uniformly; years; initial; outflow

(ex: if you loan someone $100, and they’re gonna pay you back $25 a month, the payback period is just how long it will take them to pay you back the full $100)

39
Q

When calculating the payback period, we are essentially just keeping track of the _______.

A

balance

40
Q

The Payback Rule:
An investment is acceptable if the payback period is (more than/less than) some pre-specified length of time. (we like projects that pay us back quickly)

A
  • less than
41
Q

Advantages of the Payback Rule:
1. Simple and _______ to understand.
2. Biased toward _________

A
  1. easy
  2. liquidity (if it pays back quickly, we can redeploy that capital fairly fast).
42
Q

Disadvantages of the Payback Rule:
1. Ignore the _____ ______ of money.
2. _________ cutoff.
3. _________ cash flows beyond the cutoff.
4. Biased against _______ ______ investments.

A
  1. time value
  2. arbitrary (unlike say NPV where we have a fixed rule that says positive NPV’s are good and negative NPVs are bad, with payback period, we just have to pick a number and say if it pays us back in that amount of time we’re good, if not, then it’s not so great)
  3. ignores (ex: even if a cash flow beyond the cutoff was a million, our payback period wouldn’t change, so our decision about the project wouldn’t change. Whereas, if we had a large cash flow at the end, it would make the project more valuable, which means it’s:)
  4. Biased against LONG TERM investments.
43
Q

T or F: The payback period is often used to make extremely important decisions for the company.

A

False; often used to make quick decisions that are not make or break.

44
Q

the length of time it takes for the sum of the discounted cash flows to equal the initial investment.

A

discounted payback period

45
Q

When calculating the discounted payback period, we should assume the cash flows are received ________ throughout the year.
Then, calculate the number of ______ it will take for the _____ _____ of the future cash flows to match the ______ cash outflow.

A
  • uniformly
  • years
  • present value
  • initial
46
Q

T or F: For the discounted payback period, it’s the same process as what we did with the payback period, but we need to use the PV of the cash flows instead of the regular cash flows.

A

True

47
Q

The Discounted Payback Period Rule:
An investment is acceptable if its discounted payback period is (more/less) than some pre-specified length of time.

A

less

48
Q

Advantage of the Discounted Payback Period:
Adjusts for the _____ ______ of money.

A

time value

49
Q

Disadvantages of the Discounted Payback Period:
1. ________ cutoff.
2. ________ cash flows beyond the cutoff.
3. Biased against ______ ______ investments.
4. Most of the problems of _________ ________ without the simplicity.

A
  1. arbitrary
  2. ignores
  3. long term
  4. payback period
50
Q

Which of the investment measures is by far the worst one?
Which one should you use instead if you’re already going through the trouble of discounting cash flows?

A
  • Discounted Payback Period (if you have the choice you should never use it
  • NPV
51
Q

the ratio of the average net income of the investment to the average book value of the investment

A

Average Accounting Return (ARR)

52
Q

Steps for doing calculating Average Accounting Return (ARR):
1. Calculate the average ______ ______.
2. Calculate the average ______ ______.
3. Divide

A
  • net income
  • book value
  • divide.
53
Q

How do you calculate average net income?

A

Add up all the year’s cash flows of net income and divide by the number of years.

54
Q

How do you calculate average book value?

A

(Original cost - salvage value) / 2

^ just doing the beginning and ending value divided by 2

55
Q

The ARR Rule:
An investment is acceptable if its average account return is ______ some pre-specified benchmark.

A

above

56
Q

Advantages of Average Accounting Return (ARR):
- Easy to ______.
- Needed inputs are usually ________.

A
  • calculate
  • available (just need net income and book value)
57
Q

Disadvantages of Average Accounting Return (ARR):
- ignores the ______ _____ of money.
- _________ benchmark.
- uses _______ _______, not cash flows.

A
  • time value
  • arbitrary
  • accounting values (we would rather use cash flows than accounting values if possible).

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