Net Present Value and Other Investment Rules

Question 1

Net Present Value (NPV)

= Total PV of future CFs – Initial Investment

Answer 1

Net Present Value (NPV)

= Total PV of future CFs – Initial Investment

Question 2

Estimating NPV:

1. Estimate future cash flows: how __? and ___?
2. Estimate the appropriate ____ rate
3. Estimate _____ costs

Answer 2

Estimating NPV:

1. Estimate future cash flows: how much? and when?
2. Estimate the appropriate discount rate
3. Estimate initial costs

Question 3

NPV:
Minimum Acceptance Criteria: Accept if NPV ___ 0
Ranking Criteria: Choose the ______ NPV

Answer 3

NPV:

Minimum Acceptance Criteria: Accept if NPV > 0

Question 4

Why NPV?

Accepting positive NPV projects benefits ____.

Answer 4

Why NPV?

Accepting positive NPV projects benefits shareholders.

Question 5

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).

Answer 5

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).

Question 6

Why NPV?
The value of the firm will ____ by the NPV of
the project.

Answer 6

Why NPV?
The value of the firm will increase by the NPV of
the project.

Question 7

Good Attributes of the NPV Rule:

1. Uses ___ ___ as opposed to earnings
2. Uses ____ cash flows of the project
3. Discounts ____ cash flows properly

Answer 7

Good Attributes of the NPV Rule:

1. Uses cash flows as opposed to earnings
2. Uses ALL cash flows of the project
3. Discounts ALL cash flows properly

Question 8

Reinvestment assumption: the NPV rule assumes that all cash flows can be ______ at the _____ rate.

Answer 8

Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate.

Question 9

Payback Period Rule:

Payback Period = number of _____ to ____ initial costs

• Minimum Acceptance Criteria: set by ___
• Ranking Criteria: set by ____

Answer 9

Payback Period Rule:

Payback Period = number of years to recover initial costs

• Minimum Acceptance Criteria: set by management
• Ranking Criteria: set by management

Question 10

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

Answer 10

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

Question 11

Advantages of Payback Period Rule:
– Easy to _____
– Biased toward ____

Answer 11

Advantages of Payback Period Rule:
– Easy to understand
– Biased toward liquidity

Question 12

Discounted Payback Period Rule

Decision rule: Accept the project if it ___ ___ on
a discounted basis within the specified time.

Answer 12

Discounted Payback Period Rule

Decision rule: Accept the project if it pays back on
a discounted basis within the specified time.

Question 13

Net Income = Before tax net _____ flow – ____ – _____

Answer 13

Net Income = Before tax net cash flow – Depreciation – Taxes

Question 14

Average Accounting Return (AAR) Rule:

Net Income and Book Value for the investment are _____ over the investment’s lifetime.

Answer 14

Average Accounting Return (AAR) Rule:
Net Income and Book Value for the investment are averaged over the investment’s lifetime.

• AAR fatally flawed approach

Question 15

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

Answer 15

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

Question 16

Advantages of the AAR Method:
– The accounting information is usually ___
– ____ to calculate

Answer 16

Advantages of the AAR Method:
– The accounting information is usually available
– Easy to calculate

Question 17

Internal Rate of Return (IRR)
Rule:

IRR: the discount rate that sets NPV to ___.

Answer 17

Internal Rate of Return (IRR)
Rule:

IRR: the discount rate that sets NPV to zero.

Question 18

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 ___.

Answer 18

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.

Question 19

Internal Rate of Return (IRR) Rule:

Ranking Criteria:
– Select the alternative with the ____ IRR

Answer 19

Internal Rate of Return (IRR)
Rule:

Ranking Criteria:
– Select the alternative with the highest IRR

Question 20

Internal Rate of Return (IRR) Rule:

Reinvestment assumption:
– All future cash flows assumed ______ at the IRR.

Answer 20

Internal Rate of Return (IRR)
Rule:

Reinvestment assumption:
– All future cash flows assumed reinvested at the IRR.

Question 21

Disadvantages of Internal Rate of Return (IRR) Rule:
– Does not distinguish between ____ and _____.
– IRR may not ___ or there may be ___ IRRs
– Problems with ____ ____ investments

Answer 21

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

Question 22

Advantages of Internal Rate of Return (IRR) Rule:

– Easy to ____ and _____

Answer 22

Advantages of Internal Rate of Return (IRR) Rule:

– Easy to understand and communicate

Question 23

Problems affecting the analysis of both independent and mutually exclusive projects:
– ____ IRRs.
– Are We ___ or ____?

Answer 23

Problems affecting the analysis of both independent and mutually exclusive projects:
– Multiple IRRs.
– Are We Investing or Financing?

Question 24

Problems affecting only the analysis of mutually
exclusive projects:
– The ____ Problem.
– The _____ Problem.

Answer 24

Problems affecting only the analysis of mutually
exclusive projects:
– The Scale Problem.
– The Timing Problem.

Question 25

Mutually Exclusive Projects:
only ____ of several
potential projects can be chosen, e.g., acquiring
an accounting system.
– _____ all alternatives and select the best one.

Answer 25

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.

Question 26

Independent Projects: accepting or rejecting one
project does not affect the _____ of the other
projects.
– Must exceed a _____ acceptance criteria.

Answer 26

Independent Projects: accepting or rejecting one
project does not affect the decision of the other
projects.
– Must exceed a MINIMUM acceptance criteria.

Question 27

Multiple IRRs:
A project has multiple IRRs when it has both cash
____ and ____ after the initial investment.

Answer 27

Multiple IRRs:
A project has multiple IRRs when it has both cash
inflows and outflows after the initial investment.

Question 28

Multiple IRRs:
In theory, a cash flow stream with K changes in ____
can have up to K sensible IRRs.

Answer 28

Multiple IRRs:
In theory, a cash flow stream with K changes in sign
can have up to K sensible IRRs.

Question 29

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.

Answer 29

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.

Question 30

Are we Investing or Financing?

Financing project: a project with initial cash ____ and subsequent cash _____.

Answer 30

Are we Investing or Financing?

Financing project: a project with initial cash inflows and subsequent cash outflows.

Question 31

Are we Investing or Financing?

Decision rule:
– Accept the project if IRR __ discount rate
– Reject project if IRR __ discount rate

Answer 31

Are we Investing or Financing?

Decision rule:
– Accept the project if IRR < discount rate
– Reject project if IRR > discount rate

Question 32

The IRR analysis ignores the _____ of the investment.

Answer 32

The IRR analysis ignores the scale of the investment.

Question 33

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.

Answer 33

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.

Question 34

NPV and IRR will generally give the ____ decision.

Answer 34

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

Question 35

Profitability Index (PI) Rule: 
• Minimum Acceptance Criteria:
– Accept if PI \_\_ 1
• Ranking Criteria:
– Select alternative with \_\_\_ PI

Answer 35

Profitability Index (PI) Rule: 
• Minimum Acceptance Criteria:
– Accept if PI > 1
• Ranking Criteria:
– Select alternative with highest PI

Question 36

Disadvantages of Profitability Index (PI) Rule:

– Problems with ____ ____ investments

Answer 36

Disadvantages of Profitability Index (PI) Rule:

– Problems with mutually exclusive investments

Question 37

Advantages of Profitability Index (PI) Rule:
– May be useful when available investment funds are
____
– Easy to ___ and ___
– Correct decision when evaluating _____ projects

Answer 37

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

Question 38

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)

Answer 38

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)

Question 39

Capital budgeting methods of large firms more

____ than those of small firms.

Answer 39

Capital budgeting methods of large firms more

sophisticated than those of small firms.

Question 40

Capital budgeting: The use of quantitative techniques ____ with the industry.

Answer 40

Capital budgeting: The use of quantitative techniques varies with the industry.