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Questions and Answers
When will an investment be considered further?
When will an investment be considered further?
Investment decision criteria from the internal rate of return approach are known to be:
Investment decision criteria from the internal rate of return approach are known to be:
If the present value is in excess of zero, what does it imply?
If the present value is in excess of zero, what does it imply?
Which of the following is a characteristic of the net present value approach?
Which of the following is a characteristic of the net present value approach?
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Which statement about the internal rate of return is true?
Which statement about the internal rate of return is true?
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What does a negative net present value indicate?
What does a negative net present value indicate?
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Which of the following is essential for calculating the net present value of an investment?
Which of the following is essential for calculating the net present value of an investment?
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What happens when a project's cash flows are received unevenly over time?
What happens when a project's cash flows are received unevenly over time?
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What does the internal rate of return assume about future cash flows?
What does the internal rate of return assume about future cash flows?
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When will the internal rate of return exceed the discount rate used for net present value calculation?
When will the internal rate of return exceed the discount rate used for net present value calculation?
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Which components does the internal rate of return equation incorporate?
Which components does the internal rate of return equation incorporate?
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How is net present value calculated?
How is net present value calculated?
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What is NOT considered in the internal rate of return equation?
What is NOT considered in the internal rate of return equation?
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What does a higher internal rate of return imply about an investment's potential?
What does a higher internal rate of return imply about an investment's potential?
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When is the net present value considered positive?
When is the net present value considered positive?
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Study Notes
Investment Decision Criteria
- Investment Consideration: An investment is further considered if the present value exceeds the initial outlay, the net present value is positive, and the internal rate of return surpasses the desired rate.
- Real Estate Investment Example: A $10,000 real estate investment with $3,343.81 annual cash flows for 5 years has an approximate internal rate of return of 20%.
- IRR and NPV Discrepancies: Conflicts between IRR and NPV methods arise mainly due to project size differences, differing cash flow timing, and when the reinvestment rate is significantly lower than the IRR. Perpetual cash flows are not a cause of discrepancy.
- IRR Limitations: IRR calculations are less reliable when comparing investments with varying durations.
Present Value
- Present Value Definition: Present value is the current worth of expected future benefits.
- Present Value and Return: A positive present value suggests a return exceeding the discount rate.
- Present Value and Initial Cost: Net present value (NPV) is the present value of future cash flows minus the initial cash outlay.
Internal Rate of Return (IRR)
- IRR and Reinvestment: IRR calculates the investment's return, assuming reinvestment at the same rate. This assumption can lead to inconsistencies when comparing projects.
- IRR and NPV Conflicts: An IRR calculation can lead to decisions that contradict the NPV method.
- IRR Equation: The IRR calculation incorporates the initial outlay and all future cash inflows and outflows.
- IRR and NPV Relationship: A positive NPV occurs when the IRR exceeds the discount rate used to calculate the NPV.
- IRR and Multiple Cash Flows: The IRR method can provide consistent results for projects with both positive and negative cash flows, unlike some other methods.
Net Present Value (NPV)
- NPV Formula: NPV equals the present value of expected future cash flows, minus the initial cash outlay.
- NPV and Investment Decision: A positive NPV indicates a profitable investment.
Project Comparison
- Mutually Exclusive Projects: When comparing mutually exclusive projects (only one can be chosen), consider which yields a higher NPV.
- Project Example: For an investment of $4,900 each, Project L (generating $2,400 annually for 6 years) yields a higher NPV at a 6% opportunity cost than Project S (generating $6,000 annually for 2 years).
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Description
This quiz explores the key factors in investment decision-making, including Net Present Value (NPV), Internal Rate of Return (IRR), and their respective discrepancies. You'll also learn the concept of present value and its significance in assessing investment returns.
