Podcast
Questions and Answers
What is the primary rationale for using the Net Present Value (NPV) rule in investment decisions?
What is the primary rationale for using the Net Present Value (NPV) rule in investment decisions?
- It directly measures the increase in firm value resulting from a project. (correct)
- It is simple to calculate and does not require discounting future cash flows.
- It guarantees that the project will pay back the initial investment within a specified period.
- It focuses on accounting profits rather than cash flows, providing a clearer picture of financial performance.
Which of the following best describes why the payback rule is considered less useful than the NPV rule in capital budgeting?
Which of the following best describes why the payback rule is considered less useful than the NPV rule in capital budgeting?
- The payback rule always leads to the same investment decisions as the NPV rule.
- The payback rule considers all cash flows throughout the project's life, while NPV only focuses on the initial investment.
- The payback rule is subjective and its cut-off period is arbitrary, while NPV provides an objective measure of value creation. (correct)
- The payback rule discounts future cash flows, while NPV does not.
What is a critical consideration when using the Internal Rate of Return (IRR) to evaluate mutually exclusive projects?
What is a critical consideration when using the Internal Rate of Return (IRR) to evaluate mutually exclusive projects?
- IRR always provides the same decision as NPV, so there are no specific considerations.
- IRR may lead to incorrect decisions when projects have different scales or timing of cash flows; NPV should be compared. (correct)
- Projects with higher initial investments are always preferred under the IRR rule.
- IRR is only applicable for projects with consistent positive cash flows.
You are evaluating two mutually exclusive projects. Project A has a higher NPV, but Project B has a higher IRR. Which project should you choose and why?
You are evaluating two mutually exclusive projects. Project A has a higher NPV, but Project B has a higher IRR. Which project should you choose and why?
In the context of capital budgeting, what does 'capital rationing' refer to?
In the context of capital budgeting, what does 'capital rationing' refer to?
When faced with capital rationing, which investment criterion is most suitable for selecting projects?
When faced with capital rationing, which investment criterion is most suitable for selecting projects?
Which of the following is the most important consideration when determining the appropriate discount rate for a project's cash flows?
Which of the following is the most important consideration when determining the appropriate discount rate for a project's cash flows?
When evaluating a project with a positive NPV, increasing the discount rate will generally have what effect?
When evaluating a project with a positive NPV, increasing the discount rate will generally have what effect?
When comparing assets with different lifespans, what metric is most useful in making a capital budgeting decision?
When comparing assets with different lifespans, what metric is most useful in making a capital budgeting decision?
What is the primary purpose of calculating the Equivalent Annual Cost (EAC)?
What is the primary purpose of calculating the Equivalent Annual Cost (EAC)?
In a replacement decision, you are considering replacing an old machine with a new one. What is the key factor to consider when making this decision?
In a replacement decision, you are considering replacing an old machine with a new one. What is the key factor to consider when making this decision?
What situation might lead to a project having multiple Internal Rates of Return (IRRs)?
What situation might lead to a project having multiple Internal Rates of Return (IRRs)?
Which of the following best describes the 'investment timing problem' in capital budgeting?
Which of the following best describes the 'investment timing problem' in capital budgeting?
When facing the investment timing problem, what is the decision rule to maximize firm value?
When facing the investment timing problem, what is the decision rule to maximize firm value?
What is the primary reason for projects to be mutually exclusive?
What is the primary reason for projects to be mutually exclusive?
Which of the following is a potential pitfall of using the IRR rule when evaluating projects?
Which of the following is a potential pitfall of using the IRR rule when evaluating projects?
Which is true regarding the impact of a project yielding high IRR but having a low NPV?
Which is true regarding the impact of a project yielding high IRR but having a low NPV?
A company is considering a project with a negative NPV. What does this indicate about the project?
A company is considering a project with a negative NPV. What does this indicate about the project?
A firm has a limited budget and must choose between several positive-NPV projects. Which project selection approach will maximize the total value added to the firm?
A firm has a limited budget and must choose between several positive-NPV projects. Which project selection approach will maximize the total value added to the firm?
Why is it crucial to compare NPVs today (present value) when deciding whether to postpone an investment?
Why is it crucial to compare NPVs today (present value) when deciding whether to postpone an investment?
Flashcards
Net Present Value
Net Present Value
Present value of cash flows minus initial investment.
Discount Rate
Discount Rate
The expected return rate given up by not investing in a comparable investment.
Risk and Present Value
Risk and Present Value
The process used to discount the cash flows must match the risk of the cash flows.
Payback
Payback
Signup and view all the flashcards
Internal Rate of Return (IRR)
Internal Rate of Return (IRR)
Signup and view all the flashcards
Equivalent Annual Costs (EAC)
Equivalent Annual Costs (EAC)
Signup and view all the flashcards
Capital Rationing
Capital Rationing
Signup and view all the flashcards
Profitability Index
Profitability Index
Signup and view all the flashcards
Equivalent annual cost.
Equivalent annual cost.
Signup and view all the flashcards
Net present value
Net present value
Signup and view all the flashcards
Net Present Value
Net Present Value
Signup and view all the flashcards
Study Notes
Net Present Value (NPV)
- NPV is the present value of cash flows minus the initial investment
- To decide whether to construct an office block at $350,000, predicting a $400,000 sale in a year, calculate the NPV
- Investments should be considered risk-free
Discount Rate
- The discount rate represents the expected return given up, the opportunity cost of capital
- When the interest rate on a one-year T-bill is 7%, this could be a comparable investment alternative
Risk Consideration
- The discount rate must match the risk of the cash flows
- If office development is as risky as the stock market yielding 12%, and the appropriate opportunity cost of capital is 12%
Project Evaluation
- The Net Present Value (NPV) rule is applicable to projects of any length
- Critical elements in determining NPV are cash flow amounts, timing, and the appropriate discount rate
Mutually Exclusive Projects
- Companies often choose between multiple projects, where selecting one prevents others
- For mutually exclusive projects, the project with the highest positive NPV should be chosen
Alternative Investment Criteria
- Firms sometimes use other criteria such as Payback, Discounted Payback, and Internal Rate of Return (IRR)
- Payback and Discounted Payback serve as rough guides but may lead to incorrect decisions, while IRR usually aligns with NPV
Payback Method
- Payback is the time needed for project cash flows to cover the initial investment
- Projects are accepted if payback is less than a specified cutoff point
Discounted Payback Period
- The discounted payback period adjusts for the time value of money
- Project acceptance still depends on whether the discounted payback is less than a pre-set cutoff
- Discounted payback still ignores cash flows beyond the cutoff, leading to potential rejection of positive NPV projects
Internal Rate of Return (IRR)
- IRR is where the discount rate makes the NPV of a project equal to zero
- Accept a project if the IRR exceeds the cost of capital
Pitfalls of IRR
- Project J involves lending $100 at 50% interest, while Project K involves borrowing $100 at 50% interest
- IRR is unreliable for mutually exclusive projects with different outlays, small or large
Mutually Exclusive Projects
- Small projects might have high IRR but low NPV
- Large projects might have low IRR but high NPV
Multiple Rates of Return
- Multiple rates of return occur when a project's cash flows change direction more than once
- In such cases, NPV should be used to evaluate the project
Investment Timing
- It is sometimes possible to defer an investment to a more ideal time
- Select the investment date that results in the highest NPV today
- The gain from purchasing a computer rises, but the NPV today is highest if purchased in year three
Long- and Short-Lived Equipment
- It is necessary to choose between buying two machines with differing lifespan, but identical jobs
- Machine D costs $5,000 and lasts 3 years, has $1,500 in operating costs
- Machine E costs $8,000 and lasts 5 years, has $1,000 in operating costs
Equivalent Annual Costs (EAC)
- To compare assets with different lifespans, use Equivalent Annual Costs (EAC)
- EAC is the cost per period with the same PV as buying/operating the machine
Replacement Decisions
- It is possible to operate an old machine costing $5,000 per year for two more years
- Consider a new machine which costs $8,000 and lasts four year, but produces $2,000 annually in savings, with a cost of capital of 15%
Capital Rationing
- Limit set on available investment funds
- Soft rationing is imposed by senior management
- Hard rationing is imposed by what the market is willing to allow
Profitability Index
- When funds are limited, projects are chosen based on the highest NPV per dollar of investment
- Calculate a profitability index (PI), the ratio of NPV to initial investment
- The exception to NPV is when the firm has limited resources
Shortcomings of Profitability Index
- The profitability index is an unreliable measure when choosing between mutually exclusive projects
- Small projects might have high PI with low NPV
- Large projects might have low PI with high NPV
- A higher NPV is always preferable to a higher PI
NPV as a Decision Criteria
- NPV is the best way to decide whether an investment will increase the value of the firm, and by how much
- Exceptions exist when facing capital rationing
- Despite NPV's advantages, many corporations use payback
Studying That Suits You
Use AI to generate personalized quizzes and flashcards to suit your learning preferences.
