It is ________ ________ that define the business of the firm.
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fixed assets
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Capital budgeting
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trying to determine whether a proposed investment or project will be worth more than it costs once it is in place.
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Net Present Value (NPV)
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The difference between an investment's market value and its cost.
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Net Present Value Rule:
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An investment should be accepted if the net present value is positive and rejected if it is negative.
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Discounted Cash Flow (DCF) Valuation
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(a) Valuation calculating the present value of a future cash flow to determine its value today. (b) The process of valuing an investment by discounting its future cash flows.
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If we say an investment has an NPV of $1,000, what exactly do we mean? (8.1)
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? It means that the investment should be accepted and we are creating $1,000 in value by undertaking this investment.
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Payback
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the length of time it takes to recover our initial investment, or "get our bait back"
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Payback Period
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The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.
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Payback Period Rule:
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An investment is acceptable if its calculated payback period is less than some prespecified number of years.
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Why do we say that the payback period is, in a sense, an accounting break-even measure? (8.2)
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? Because time value is ignored, you can think of the payback period as the length of time it takes to break-even in the accounting sense, but not in an economic sense.
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What's the biggest drawback to the Payback Rule?
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It doesn't ask the right question.
- The relevant issue is the impact an investment will have on the value of our stock, not how long it takes to recover the initial investment.
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Internal Rate of Return (IRR)
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The discount rate that makes the net present value of an investment zero.
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IRR Rule:
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An investment is acceptable if the IRR exceeds the required return, it should be rejected otherwise.
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How do you find the IRR on a NPV Profile graph?
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IRR is the % where the curve crosses the horizontal surface.
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Net Present Value Profile
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A graphical representation of the relationship between an investment's net present values and various discount rates.
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Multiple Rates of Return
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The possibility that more than one discount rate will make the net present value of an investment zero.
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Mutually Exclusive Investment Decisions
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A situation where taking one investment prevents the taking of another.
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Under what circumstances will the IRR and NPV rules lead to the same accept-reject decisions? When might they conflict? (8.4)
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?
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Is it generally true that an advantage of the IRR rule over the NPV rule is that we don't need to know the required return to use the IRR rule? (8.4)
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?
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Profitability Index (PI) (also called cost benefit ratio)
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The present value of an investment's future cash flows divided by its initial cost.
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What does the profitability index measure? (8.5)
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?
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How would you state the profitability index rule? (8.5)
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?
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What are the most commonly used capital budgeting procedures? (8.6)
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?
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Since NPV is conceptually the best tool for capital budgeting, why do you think multiple measures are used in practice? (8.6)
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?
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A project has the following projected cash flows. What is the project's net present value if the discount rate is 14 percent?
Year Cash Flow
0 -$ 597,000
1 169,400
2 302,500
3 365,800
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$31,265.00
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The NPV rule states that an independent project should be accepted if the NPV:
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is positive.
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A project has the following projected cash flows. What is the project's payback period?
Year Cash Flow
0 -$ 162,500
1 69,700
2 76,000
3 78,300
4 62,500
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2.21 years
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Which one of the following statements is correct regarding the payback method?
-The payback method is rarely used in business today.
-The payback rule states that a project should be accepted if the payback period exceeds the required period.
-The payback method favors short-term projects.
-The payback method considers the time value of money.
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- The payback method favors short-term projects.
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A project has an initial cost of $500,000 and projected net income of $44,000, $48,000, and $51,000 a year for the three years of the project, respectively. The initial cost will be depreciated on a straight-line basis over the life of the project. What is the accounting rate of return for this project?
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19.07 percent
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Which one of the following best describes an advantage of the AAR method?
-requiring only easily obtainable information
-using an arbitrary required return
-evaluating a project based on net income rather than cash flow
-ignoring time value of money
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-requiring only easily obtainable information
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Which one of the following statements related to the IRR is correct?
-The IRR rule results in the same accept or reject decision as the NPV rule when a project is independent.
-There can be multiple IRRs when the cash flows are conventional.
-You should reject an independent project if the IRR exceeds the required return.
-The IRR rule can be used to make accept and reject decisions for both independent and mutually exclusive projects.
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-The IRR rule results in the same accept or reject decision as the NPV rule when a project is independent.
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A project has the following cash flows. What is the IRR?
Year Cash Flow
0 -$ 270,500
1 104,200
2 122,800
3 137,900
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15.77 percent
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A proposed project has a PI of 1.13. This means that the project returns $1.13 in:
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cash inflows in today's dollars for every $1 of initial cost.
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A project has the following cash flows. What is the PI at a discount rate of 12 percent?
Year Cash Flow
0 -$ 242,800
1 129,200
2 157,500
3 188,100
