Net Present Value and Other Investment Rules Flashcards
Net Present Value (NPV)
= Total PV of future CFs – Initial Investment
Net Present Value (NPV)
= Total PV of future CFs – Initial Investment
Estimating NPV:
- Estimate future cash flows: how __? and ___?
- Estimate the appropriate ____ rate
- Estimate _____ costs
Estimating NPV:
- Estimate future cash flows: how much? and when?
- Estimate the appropriate discount rate
- Estimate initial costs
NPV:
Minimum Acceptance Criteria: Accept if NPV ___ 0
Ranking Criteria: Choose the ______ NPV
NPV:
Minimum Acceptance Criteria: Accept if NPV > 0
Why NPV?
Accepting positive NPV projects benefits ____.
Why NPV?
Accepting positive NPV projects benefits shareholders.
Why NPV?
The value of the firm is the ____ of the values of the
different projects, divisions, or other entities within the firm (value additivity property).
Why NPV?
The value of the firm is the sum of the values of the
different projects, divisions, or other entities within the firm (value additivity property).
Why NPV?
The value of the firm will ____ by the NPV of
the project.
Why NPV?
The value of the firm will increase by the NPV of
the project.
Good Attributes of the NPV Rule:
- Uses ___ ___ as opposed to earnings
- Uses ____ cash flows of the project
- Discounts ____ cash flows properly
Good Attributes of the NPV Rule:
- Uses cash flows as opposed to earnings
- Uses ALL cash flows of the project
- Discounts ALL cash flows properly
Reinvestment assumption: the NPV rule assumes that all cash flows can be ______ at the _____ rate.
Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate.
Payback Period Rule:
Payback Period = number of _____ to ____ initial costs
- Minimum Acceptance Criteria: set by ___
- Ranking Criteria: set by ____
Payback Period Rule:
Payback Period = number of years to recover initial costs
- Minimum Acceptance Criteria: set by management
- Ranking Criteria: set by management
Disadvantages of Payback Period Rule:
– Ignores the ____ value of money
– Ignores cash flows ___ the payback period
– Biased against ___-term projects
– Arbitrary _____ criteria
– A project accepted based on the payback criteria may not have a ____ NPV
Disadvantages of Payback Period Rule:
– Ignores the time value of money
– Ignores cash flows after the payback period
– Biased against long-term projects
– Arbitrary acceptance criteria
– A project accepted based on the payback criteria may not have a positive NPV
Advantages of Payback Period Rule:
– Easy to _____
– Biased toward ____
Advantages of Payback Period Rule:
– Easy to understand
– Biased toward liquidity
Discounted Payback Period Rule
Decision rule: Accept the project if it ___ ___ on
a discounted basis within the specified time.
Discounted Payback Period Rule
Decision rule: Accept the project if it pays back on
a discounted basis within the specified time.
Net Income = Before tax net _____ flow – ____ – _____
Net Income = Before tax net cash flow – Depreciation – Taxes
Average Accounting Return (AAR) Rule:
Net Income and Book Value for the investment are _____ over the investment’s lifetime.
Average Accounting Return (AAR) Rule:
Net Income and Book Value for the investment are averaged over the investment’s lifetime.
- AAR fatally flawed approach
Disadvantages of the AAR Method:
– Ignores the ___ value of money
– Uses an arbitrary ___ __ rate
– Based on net ___ and book ___, not cash flows and market values
Disadvantages of the AAR Method:
– Ignores the time value of money
– Uses an arbitrary benchmark cutoff rate
– Based on net income and book values, not cash flows and market values
Advantages of the AAR Method:
– The accounting information is usually ___
– ____ to calculate
Advantages of the AAR Method:
– The accounting information is usually available
– Easy to calculate
Internal Rate of Return (IRR)
Rule:
IRR: the discount rate that sets NPV to ___.
Internal Rate of Return (IRR)
Rule:
IRR: the discount rate that sets NPV to zero.
Internal Rate of Return (IRR)
Rule:
Minimum Acceptance Criteria:
– Accept if the IRR ____ the required rate of return.
• Required rate of return = the return _____ on the project
given its ___.
Internal Rate of Return (IRR)
Rule:
Minimum Acceptance Criteria:
– Accept if the IRR exceeds the required rate of return.
• Required rate of return = the return required on the project
given its risk.
Internal Rate of Return (IRR) Rule:
Ranking Criteria:
– Select the alternative with the ____ IRR
Internal Rate of Return (IRR)
Rule:
Ranking Criteria:
– Select the alternative with the highest IRR
Internal Rate of Return (IRR) Rule:
Reinvestment assumption:
– All future cash flows assumed ______ at the IRR.
Internal Rate of Return (IRR)
Rule:
Reinvestment assumption:
– All future cash flows assumed reinvested at the IRR.
Disadvantages of Internal Rate of Return (IRR) Rule:
– Does not distinguish between ____ and _____.
– IRR may not ___ or there may be ___ IRRs
– Problems with ____ ____ investments
Disadvantages of Internal Rate of Return (IRR) Rule:
– Does not distinguish between investing and borrowing.
– IRR may not exist or there may be multiple IRRs
– Problems with mutually exclusive investments
Advantages of Internal Rate of Return (IRR) Rule:
– Easy to ____ and _____
Advantages of Internal Rate of Return (IRR) Rule:
– Easy to understand and communicate
Problems affecting the analysis of both independent and mutually exclusive projects:
– ____ IRRs.
– Are We ___ or ____?
Problems affecting the analysis of both independent and mutually exclusive projects:
– Multiple IRRs.
– Are We Investing or Financing?
Problems affecting only the analysis of mutually
exclusive projects:
– The ____ Problem.
– The _____ Problem.
Problems affecting only the analysis of mutually
exclusive projects:
– The Scale Problem.
– The Timing Problem.
Mutually Exclusive Projects:
only ____ of several
potential projects can be chosen, e.g., acquiring
an accounting system.
– _____ all alternatives and select the best one.
Mutually Exclusive Projects:
only ONE of several
potential projects can be chosen, e.g., acquiring
an accounting system.
– RANK all alternatives and select the best one.
Independent Projects: accepting or rejecting one
project does not affect the _____ of the other
projects.
– Must exceed a _____ acceptance criteria.
Independent Projects: accepting or rejecting one
project does not affect the decision of the other
projects.
– Must exceed a MINIMUM acceptance criteria.
Multiple IRRs:
A project has multiple IRRs when it has both cash
____ and ____ after the initial investment.
Multiple IRRs:
A project has multiple IRRs when it has both cash
inflows and outflows after the initial investment.
Multiple IRRs:
In theory, a cash flow stream with K changes in ____
can have up to K sensible IRRs.
Multiple IRRs:
In theory, a cash flow stream with K changes in sign
can have up to K sensible IRRs.
Multiple IRRs:
If the initial cash flow is negative (positive) and all the remaining cash flows are positive (negative) there could only be a ____, ____ IRR.
Multiple IRRs:
If the initial cash flow is negative (positive) and all the remaining cash flows are positive (negative) there could only be a single, unique IRR.
Are we Investing or Financing?
Financing project: a project with initial cash ____ and subsequent cash _____.
Are we Investing or Financing?
Financing project: a project with initial cash inflows and subsequent cash outflows.
Are we Investing or Financing?
Decision rule:
– Accept the project if IRR __ discount rate
– Reject project if IRR __ discount rate
Are we Investing or Financing?
Decision rule:
– Accept the project if IRR < discount rate
– Reject project if IRR > discount rate
The IRR analysis ignores the _____ of the investment.
The IRR analysis ignores the scale of the investment.
Timing Problem:
Problem of the timing of cash flows on two different
projects can be resolved using one of three methods:
1. Compare ___ of the two projects.
2. Compute incremental ___ – and compare to _____
rate.
3. Calculate the ___ on the incremental cash flows.
Timing Problem:
Problem of the timing of cash flows on two different
projects can be resolved using one of three methods:
1. Compare NPVs of the two projects.
2. Compute incremental IRR – determine the incremental cash flows between the two projects and calculate this IRR – and compare to discount
rate.
3. Calculate the NPV on the incremental cash flows.
NPV and IRR will generally give the ____ decision.
NPV and IRR will generally give the same decision.
Exceptions:
– Non-conventional cash flows – cash flow signs change
more than once
– Mutually exclusive projects
• Initial investments are substantially different
• Timing of cash flows is substantially different
Profitability Index (PI) Rule: • Minimum Acceptance Criteria: – Accept if PI \_\_ 1 • Ranking Criteria: – Select alternative with \_\_\_ PI
Profitability Index (PI) Rule: • Minimum Acceptance Criteria: – Accept if PI > 1 • Ranking Criteria: – Select alternative with highest PI
Disadvantages of Profitability Index (PI) Rule:
– Problems with ____ ____ investments
Disadvantages of Profitability Index (PI) Rule:
– Problems with mutually exclusive investments
Advantages of Profitability Index (PI) Rule:
– May be useful when available investment funds are
____
– Easy to ___ and ___
– Correct decision when evaluating _____ projects
Advantages of Profitability Index (PI) Rule:
– May be useful when available investment funds are
limited
– Easy to understand and communicate
– Correct decision when evaluating independent projects
Practice of Capital Budgeting:
– ____ by industry and company
Common:
– NPV (about __% of Canadian companies)
– IRR (about __% of Canadian companies)
– Payback period (about __% of Canadian companies)
Practice of Capital Budgeting:
– varies by industry and company
Common:
– NPV (about 75% of Canadian companies)
– IRR (about 70% of Canadian companies)
– Payback period (about 70% of Canadian companies)
Capital budgeting methods of large firms more
____ than those of small firms.
Capital budgeting methods of large firms more
sophisticated than those of small firms.
Capital budgeting: The use of quantitative techniques ____ with the industry.
Capital budgeting: The use of quantitative techniques varies with the industry.
