Topic 4

Question 1

Net present value (NPV) is the difference between an investment’s ________ (in today’s dollars) and its cost (also in today’s dollars).

Answer 1

market value

Question 2

NPV = _____ of future cashflows - Outlay

Answer 2

PV

Question 3

The important elements in making financial decisions are:

• the cash flows
• the ______ of the cash flows and
• the ____ of the cash flows.

Answer 3

timing; risk

Question 4

Does the NPV rule account for the _______ of money? YES

Answer 4

time value

Question 5

Does the NPV rule account for the ____ of the cash flows? YES

Answer 5

risk

Question 6

Does the NPV rule provide an indication about the increase in _____? YES

Answer 6

value

Question 7

Should we consider the NPV rule for our _______ decision rule ? YES

Answer 7

primary

Question 8

Payback period is the amount of _____ required for an investment to generate cash flows to recover its initial cost.

Answer 8

time

Question 9

Advantages of Payback:

• Easy to _________.
• Adjusts for ________ of later cash flows.
• Biased towards liquidity.

Answer 9

understand; uncertainty

Question 10

Disadvantages of Payback
- ______of money and risk ignored.
Ignores cash flows beyond the ______.
- Biased against long-term and new projects

Answer 10

Time value; cut-off date

Question 11

Discounting payback period is the length of time required for an investment’s discounted cash flows to equal its ______ cost.

Answer 11

initial

Question 12

Discounted payback period

• Takes into account the ____ of money.
• More difficult to calculate.
• An investment is acceptable if its discounted payback is less than some prescribed number of years.

Answer 12

time value

Question 13

• Does the discounted payback rule account for the ______ of money? YES
• Does the discounted payback rule account for the risk of the cash flows? YES
• Does the discounted payback rule provide an ________about the increase in value? NO
• Should we consider the discounted payback rule for our primary decision rule? NO
  NOTE: The answer to the third question is no, because of the arbitrary cut-off date.
  Since the rule does not indicate whether or not we are creating value for the firm, it should not be the primary decision rule

Answer 13

time value; indication

Question 14

Advantages of Discounted Payback

• Includes ______of money
• Easy to understand
• Does not accept negative estimated
• _____ investments
• Biased towards liquidity.

Answer 14

time value; NPV

Question 15

Disadvantages of Discounted Payback

• May reject positive NPV investments
• Arbitrary ________ of acceptable payback period
• _______cash flows beyond the cut-off date
• Biased against long-term and new products.

Answer 15

determination; Ignores

Question 16

Accounting Rate of Return (ARR)

An investment’s average _______ divided by its average ________.

A project is _______if ARR > target average accounting return.

Answer 16

net income; book value; accepted

Question 17

Advantages of ARR

• Easy to _____ and understand.
• Accounting information almost always available

Answer 17

calculate

Question 18

Disadvantages of ARR

• The measure is not a ‘true’ reflection of return.
• Time value is ______.
• Arbitrary determination of target average return.
• Uses profit and ______instead of cash flow and market value.

Answer 18

ignored; book value

Question 19

• Does the ARR rule account for the time value of money?
• Does the ARR rule account for the risk of the cash flows?
• Does the ARR rule provide an indication about the increase in value?
• Should we consider the ARR rule for our primary decision rule?

value.

Answer 19

NOTE: The answer to all of these questions is no. In fact, this rule is even worse than the payback rule in that it doesn’t even use cash flows for the analysis. It uses net income and book

Question 20

A project is accepted if:

IRR > the __________

Answer 20

required rate of return

Question 21

Advantages of IRR:

• Popular in practice.
• Does not require ________.
• The IRR appears to provide a simple way of communicating information about a _______ .

Answer 21

a discount rate; proposal

Question 22

Problems with IRR:

• Multiple rates of return

+ Occurs if more than one _______ makes the NPV of an investment zero.
+ This will happen when there is more than one _________ (non-conventional cash flows).

Answer 22

discount rate; negative cash flow

Question 23

Problems with IRR

• Mutually exclusive investment decisions

+ Project is not independent —-» ________.
+ Highest IRR does not indicate ________.

Answer 23

mutually exclusive investments; the best project

Question 24

Cross over rate is the rate at which one is indifferent in choosing one investment over the other or vice versa, in case of mutually exclusive investments
Calculation of cross over rate
- If there are two mutually exclusive projects A & B with the given cash flows
	Project A	  Project B	Difference
	-100		   -100		0	
	30		    49		-19	
	50		    49		1
	70		    49		21

The IRR of these cashflows is the cross over rate

Input 0 DATA, 19+/- DATA, 1 DATA, 21 DATA
2ndF CASH 2ndF CA
Press COMP

===> answer

Answer 24

Answer: 7.79% is the cross over rate

Question 25

• The present value index is the present value of an investment’s _____cash flows divided by its initial cost

PVI = PV of inflows/ / Initial cost

• The PVI is also known as the benefit/cost ratio.
• Accept a project with a PVI > ____
• It measures value created per dollar invested

Answer 25

future; 1.0.

Question 26

• The net present value index is the net present value of the ______ cash flows divided by the initial investment.

NPVI = NPV of cash flows / Initial cost

• The NPVI differs from the PVI by a _____ of one.
• The ranking problems associated with the PVI are also applicable to the NPVI.

Answer 26

future; scale