Session 4- Net Present Value

Question 1

Why use NPV

Answer 1

Positive NPV projects benefits stockholders as it shows that the business will increase in value and accounts for the time value of money

NPV uses cash flows
NPV uses all the cash flows of the project
NPV discounts the cash flows

Question 2

What is the NPV Rule?

Answer 2

NPV= PV of future cash flows + initial investment

Question 3

Minimum acceptance criteria and ranking criteria of NPV

Answer 3

Minimum acceptance criteria- Accept if NPV is more than or equal to 0
Ranking: Project with the Highest NPV

Question 4

What is the payback method?

Answer 4

Identifies how long it takes the project to “pay back” its initial investment
Payback period+ number of years to recover initial investment

Acceptance and ranking criteria set by mgmt

Question 5

Disadvantages of the Payback Method

Answer 5

*Ignores the time value of money
*ignores cash flows after the payback period
*biased against long-term projects
*requires an arbitrary acceptance criteria

Question 6

Advantages of the payback method

Answer 6

*Easy to understand
*Biased toward liquidity

Question 7

What is the discounted payback period?

Answer 7

identifies how it takes the project to pay back its initial investment, taking the time value of money into account.

Question 8

What is the IRR

Answer 8

The internal rate of return is the disc rate that sets the NPV to 0
Accept if the IRR exceeds the ROR

Question 9

What is the PI?

Answer 9

Profitability index= PV of cash flows after initial investment/initial investment

Accept is more than 1

Question 10

NPV vs IRR

Answer 10

Generally gives the same answer

EXCEPTIONS
Non-conventional cfs
Mutually exclusive projects

Question 11

What is cash payback period?

Answer 11

identifies the time period required to recover the cost of capital investment from net annual cash inflow.
Costs of cap investment/ net annual cf= cash payback

Shorter payback period= more attractive investment

Cumulative net cash flows from investment= Cost of investment

Question 12

What is the discount rate?

Answer 12

A discount rate is the rate of return used to discount future cash flows back to their present value.
Essentially, it represents the time value of money by accounting for the fact that money earned in the future is less valuable than money earned today.

In most instances a company uses a required rate of return equal to its cost of capital- that is, the rate that it must pay to obtain funds from creditors and stockholder.

Also called the rate of return, hurdle rate and cutoff rate

Question 13

Things that matter when it comes to capital budgeting (think costs)

Answer 13

*Cash flows matter- not accounting earnings
*Sunk costs do NOT matter
*Incremental cash flows matter
*Opportunity costs matter
*Taxes matter