Net present value and other investment appraisal rules

Question 1

Which investments should you accept and which should you reject based on NPV

Answer 1

Accept ones with a positive NPV and reject ones with a negative NPV

Question 2

What is the payback period

Answer 2

Number of years that it takes before the forecasted cumulative cash flow equals the initial outlay

Question 3

4 Drawbacks of using the payback period

Answer 3

Ignores the time value of money
Requires an arbitrary cutoff point
Ignores cash flows beyond the cutoff date
Biased against long-term and new project

Question 4

Which investments should you accept and which should you reject based on payback period

Answer 4

Accept a project that has a calculated payback period of less than a pre-specified number of years
Reject a project that has a calculated payback period of more than a pre-specified number of years

Question 5

What is the discounted payback period

Answer 5

The length of time until the sum of the discounted cash flows is equal to the initial investment

Question 6

What is the internal rate of return

Answer 6

The discount rate that makes NPV equal to 0

Question 7

Which investments should you accept and which should you reject based on IRR

Answer 7

Accept investments where IRR is greater than a pre-specified discount rate.
Reject investments if IRR is less than the pre-specified discount rate

Question 8

3 Drawbacks of using the IRR

Answer 8

With nonconventional cash flows, the NPV of the project increases as the discount rate increases.
Multiple rates of return: cash flows can generate NPV = 0 at two different discount rates.
For mutually exclusive investments, IRR sometimes ignores the magnitude of the project

Question 9

Advantage of AAR

Answer 9

Simple returns-based measure

Question 10

3 Disadvantages of AAR

Answer 10

Does not use cash flows
Does not use time value of money
Arbitrary target rate