Flashcards in Topic 4 Deck (26)
Net present value (NPV) is the difference between an investment’s ________ (in today’s dollars) and its cost (also in today’s dollars).
NPV = _____ of future cashflows - Outlay
The important elements in making financial decisions are:
- the cash flows
- the ______ of the cash flows and
- the ____ of the cash flows.
Does the NPV rule account for the _______ of money? YES
Does the NPV rule account for the ____ of the cash flows? YES
Does the NPV rule provide an indication about the increase in _____? YES
Should we consider the NPV rule for our _______ decision rule ? YES
Payback period is the amount of _____ required for an investment to generate cash flows to recover its initial cost.
Advantages of Payback:
- Easy to _________.
- Adjusts for ________ of later cash flows.
- Biased towards liquidity.
Disadvantages of Payback
- ______of money and risk ignored.
Ignores cash flows beyond the ______.
- Biased against long-term and new projects
Time value; cut-off date
Discounting payback period is the length of time required for an investment’s discounted cash flows to equal its ______ cost.
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.
- 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
time value; indication
Advantages of Discounted Payback
- Includes ______of money
- Easy to understand
- Does not accept negative estimated
- _____ investments
- Biased towards liquidity.
time value; NPV
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.
Accounting Rate of Return (ARR)
An investment’s average _______ divided by its average ________.
A project is _______if ARR > target average accounting return.
net income; book value; accepted
Advantages of ARR
- Easy to _____ and understand.
- Accounting information almost always available
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.
ignored; book value
- 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?
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
A project is accepted if:
IRR > the __________
required rate of return
Advantages of IRR:
- Popular in practice.
- Does not require ________.
- The IRR appears to provide a simple way of communicating information about a _______ .
a discount rate; proposal
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).
discount rate; negative cash flow
Problems with IRR
- Mutually exclusive investment decisions
+ Project is not independent ---->> ________.
+ Highest IRR does not indicate ________.
mutually exclusive investments; the best project
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
Answer: 7.79% is the cross over rate
- 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