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Finance > Net Present Value and Other Investment Rules > Flashcards

Net Present Value and Other Investment Rules Flashcards

1
Q

Net Present Value (NPV)

= Total PV of future CFs – Initial Investment

A

Net Present Value (NPV)

= Total PV of future CFs – Initial Investment

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2
Q

Estimating NPV:

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

Estimating NPV:

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

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

A

NPV:

Minimum Acceptance Criteria: Accept if NPV > 0

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4
Q

Why NPV?

Accepting positive NPV projects benefits ____.

A

Why NPV?

Accepting positive NPV projects benefits shareholders.

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5
Q

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).

A

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).

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6
Q

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

A

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

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7
Q

Good Attributes of the NPV Rule:

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

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
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8
Q

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

A

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

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9
Q

Payback Period Rule:

Payback Period = number of _____ to ____ initial costs

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

Payback Period Rule:

Payback Period = number of years to recover initial costs

  • Minimum Acceptance Criteria: set by management
  • Ranking Criteria: set by management
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10
Q

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

A

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

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11
Q

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

A

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

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12
Q

Discounted Payback Period Rule

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

A

Discounted Payback Period Rule

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

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13
Q

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

A

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

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14
Q

Average Accounting Return (AAR) Rule:

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

A

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

  • AAR fatally flawed approach
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15
Q

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

A

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

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16
Q

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

A

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

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17
Q

Internal Rate of Return (IRR)
Rule:

IRR: the discount rate that sets NPV to ___.

A

Internal Rate of Return (IRR)
Rule:

IRR: the discount rate that sets NPV to zero.

18
Q

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 ___.

A

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.

19
Q

Internal Rate of Return (IRR) Rule:

Ranking Criteria:
– Select the alternative with the ____ IRR

A

Internal Rate of Return (IRR)
Rule:

Ranking Criteria:
– Select the alternative with the highest IRR

20
Q

Internal Rate of Return (IRR) Rule:

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

A

Internal Rate of Return (IRR)
Rule:

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

21
Q

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

A

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

22
Q

Advantages of Internal Rate of Return (IRR) Rule:

– Easy to ____ and _____

A

Advantages of Internal Rate of Return (IRR) Rule:

– Easy to understand and communicate

23
Q

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

A

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

24
Q

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

A

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

25
Q

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

A

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.

26
Q

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

A

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

27
Q

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

A

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

28
Q

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

A

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

29
Q

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.

A

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.

30
Q

Are we Investing or Financing?

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

A

Are we Investing or Financing?

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

31
Q

Are we Investing or Financing?

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

A

Are we Investing or Financing?

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

32
Q

The IRR analysis ignores the _____ of the investment.

A

The IRR analysis ignores the scale of the investment.

33
Q

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.

A

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.

34
Q

NPV and IRR will generally give the ____ decision.

A

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

35
Q 
Profitability Index (PI) Rule: 
• Minimum Acceptance Criteria:
– Accept if PI \_\_ 1
• Ranking Criteria:
– Select alternative with \_\_\_ PI
A 
Profitability Index (PI) Rule: 
• Minimum Acceptance Criteria:
– Accept if PI > 1
• Ranking Criteria:
– Select alternative with highest PI
36
Q

Disadvantages of Profitability Index (PI) Rule:

– Problems with ____ ____ investments

A

Disadvantages of Profitability Index (PI) Rule:

– Problems with mutually exclusive investments

37
Q

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

A

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

38
Q

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)

A

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)

39
Q

Capital budgeting methods of large firms more

____ than those of small firms.

A

Capital budgeting methods of large firms more

sophisticated than those of small firms.

40
Q

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

A

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

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