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Chapter 5 Financial Policies
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Terms in this set (26)
According to the basic investment rule for NPV, a firm should:
*accept the project of NPV>0
*be indifferent about the project is NPV = 0
*reject the project if NPV<0
For "normal" cash flows (the outflows occur before the inflows) the NPV is ... if the discount rate is less than the IRR, and it is ... if the discount rate rate is greater than the IRR
positive; negative
For a project with a negative initial cash flow, followed by positive cash flows, it should be rejected if
*the NPV is less than 0
*the IRR is less than the market rate of financing
The steps involved in the discounted payback period are:
1) Discount the Cash Flows using the Discount Rate
2) Add the discounted Cash Flows
3) Accept if the discounted payback period is less than some pre-specified number of years
What does value additivity mean for a firm?
*The value of a firm is simply the combined value of the firms projects, divisions, and entities owned by the firm
*the NPV values of individual projects can be added together
A dollar received a year from today has ... value than a dollar received today
less
According to the basic IRR rule, a project should be:
*Accepted if IRR > Discount Rate
*Rejected if IRR < Discount Rate
The discount rate assigned to a project reflects the:
*Risk of a project
*Opportunity cost to the investor
The three attributes of NPV are:
*It uses all of the cash flows for a project
*Discounts the cash flows properly
*Uses cash flow
The internal rate of return is a function of
a project's cash flows
According to Graham and Harvey's 1999 survey, which of the following two capital budgeting methods are most used by firms in the US & Canada?
NPV & IRR
This capital budgeting methods allows lower management to make smaller, everyday financial decisions easily:
payback method
What are some weaknesses of the payback method?
*Time Value of Money principals are ignored
*Cash flows received after the payback period are ignored
*The cutoff date is arbitrary
The discounted payback period has what weaknesses?
*Arbitrary cutoff
*Loss of simplicity
*Exclusion of some cash flows
Two mutually exclusive projects can be correctly evaluated by
*Examining the NPV of the incremental cash flows
*Comparing the NPVs of the two projects
*Comparing the incremental IRR to the discount rate
Capital ... is the decision making process for accepting and rejecting projects
Budgeting
With mutually exclusive projects, the profitability index suffers from the same problem that the IRR rule does in that it fails to consider
the size or scale of projects
The payback period rule ... a project if it has a payback period that is less than or equal to a particular cutoff date
accepts
The problems with scale in the profitability index can be corrected by using ... analysis
incremental
The dollar difference in value between mutually exclusive projects can be found by calculating the ... of the incremental cash flows
NPV
The IRR is the discount rate that makes the NPV of a project equal to
0
What is the best tool for ranking projects in the presence of capital rationing?
Profitability Index
The PI rule for an independent project is to ... the project if the PI is greater than 1
accept
A project with an initial cash outflow followed by a cash inflow will have an NPV that will decreases as discount rates ...
increase
The NPV of a project's cash flows is divided by the ... to calculate the profitability index
initial investment
The discount rate is determined by the ... of a project
risk
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