Net Present Value and Other Investment Rules Flashcards
NPV Investment Rule
Accept if NPV is greater than Zero
Reject if NPV is less than Zero
Strengths of NPV
Uses cash flows
Uses all cash flows
Discounts cash flows
Payback Period Method
Accept if payback period is less than benchmark
Reject if payback period is greater than benchmark
Problems with the payback period
timing of cash flows
payments after the payback period
arbitrary standard for the payback period
Advantages of Payback Period
very small scale investments
firms with severe capital rationing
exceptionally simple to understand
Discounted Payback Period
accept if discounted payback period is less than benchmark
reject if discounted payback period is greater than benchmark
Strengths of discounted payback period
simple
uses time value money
weaknesses of discounted payback pd
ignores cash flows beyond benchmark
arbitrary benchmark
the average accounting return method
average accounting return is greater than target return
average accounting return is less than target return
Steps to average accounting return
determine average net income
determine average investment
determine average accounting return
Strengths of the average accounting return
simple return based measure
weaknesses of the average accounting return
does not use cash flows
does not use time value of money
arbitrary target rate
The internal rate of return
accept internal rate of return if it is greater than the discount rate
reject the internal rate of return if it is less than discount rate
Must find the internal rate of return that sets NPV equal to
zero
Independent project definition
one whose acceptance or rejection is independent of the acceptance or rejection of other projects.
IRR Problems Specific to mutually exclusive projects
ignores scale of cash flows
ignores timing of cash flows
The profitability index is applied to
independent projects
mutually exclusive projects
capital rationing
Profitability index: Independent Projects
accept if index is greater than 1
reject if index is less than 1
Profitability Index: Mutually Exclusive Projects
Accept if profitability index is greater than 1
Reject if profitability index is less than 1
Capital Rationing
Capital Rationing occurs when there is not enough cash to invest in all positive NPV projects
Under Capital Rationing you cannot rank projects according to NPV
Should use profitability index or incremental NPV
