Corporate Finance Chapters 8 & 9
Terms in this set (30)
Net Present Value NPV
The difference between an investments market value and its cost.
Discounted Cash Flow DCF Valuation
The process of valuing an investment by discounting its future cash flows.
An investment should be accepted if the net present value is
positive and rejected if it is negative.
The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.
Based on the payback rule, an investment is acceptable if its calculated payback period is
less than some specified number of years.
Average Accounting Return AAR
An investments average net income divided by its average book value.
Advantages to the average accounting return AAR
1. Easy to calculate.
2. Needed information will usually be available.
Disadvantages to the average accounting return AAR
1. Not a true rate of return; time value of money is ignored.
2. Uses an arbitrary benchmark cutoff rate.
3. Based on accounting net income and book values, not cash flows and market values.
Internal Rate of Return IRR
The discount rate that makes the NPV of an investment zero.
Based on the IRR rule, an investment is acceptable if the IRR
exceeds the required return. It should be rejected otherwise.
The IRR on an investment is the required return that results in
a zero NPV when it is used as the discount rate.
Mutually exclusive Investment Decisions
A situation where taking one investment prevents the taking of another.
Profitability Index PI
The present value of an investments future cash flows divided by its initial cost. Also, benefit cost ratio.
Advantages of the Profitability Index PI
1. Closely related to NPV, generally leading to identical decisions.
2. Easy to understand and communicate.
3. May be useful when available investment funds are limited.
Disadvantages of the Profitability Index PI
1. May lead to incorrect decisions in comparisons of mutually exclusive investments.
Suppose a project has conventional cash flows and a positive NPV. What do you know about its payback? It's profitability index? Its IRR?
1. The payback period must be less than the amount of time it takes to complete the project.
2. The Profitability index PI would have to be greater than 1 because if the NPV is positive, that means the present value of future cash is greater than the required return.
3. The IRR would be greater than the required return since NPV is positive for a certain discount rate, then it would be 0 for a larger discount rate.
Describe how the payback period is calculated and describe the information this measure provides about a sequence of cash flows.
Payback period is the amount of time required for an investment to generate cash flows sufficient to recover its initial cost.
What is the payback criterion decision rule?
The decision rule is when you accept or reject a project based on a cutoff period.
What are the problems associated with using the payback period as a means of evaluating cash flows?
1. It ignores the time value of money.
2. It ignores cash flows beyond cutoff period.
3. Requires an arbitrary period.
4. Biased against long term projects.
What are the advantages of using the payback period to evaluate cash flows?
The advantages include it being a simple analysis that can be used to determine what short term projects should be accepted or rejected.
Are there any circumstances under which using payback period might be appropriate?
Since payback is biased towards liquidity, it may be a useful and appropriate analysis method for short term projects where cash management is most important.
Describe how Net Present Value NPV is calculated and describe the information this measure provides about a sequence of cash flows.
NPV is the sum of the present values of a projects cash flows. Its measures the net increase or decrease in firm wealth due to the project.
What is the NPV criterion decision rule?
The NPV decision rule is to accept projects that have a positive NPV and reject projects with a negative NPV.
Why is NPV considered to be a superior method of evaluating the cash flows from a project?
There is only one NPV. It tells you directly in todays dollars how much the shareholders wealth has gone up.
Describe how the profitability index is calculated and the describe the information this measure provides about a sequence of cash flows.
The profitability index is the present value of cash inflows relative to the project cost. As such, it is a benefit/cost ratio, providing a measure of the relative profitability of a project.
What is the Profitability Index PI decision rule?
The profitability index decision rule is to accept projects with a PI greater than one, and to reject projects with a PI less than one.
A cost that has already been incurred and cannot be recouped and therefore should not be considered in an investment decision.
The most valuable alternative that is given up if a particular investment is undertaken.
The cash flows of a new project that come at the expense of a firms existing projects.
Accelerated Cost Recovery System ACRS
Depreciation method under U.S. tax law allowing for the accelerated write off of property under various classifications.