Module 32.2: Payback Period, Project Rankings Flashcards
What is the payback period? What is the formula?
the number of years it takes to recover the initial cost of an investment.
full years until recovery + [unrecovered cost at beginning of recovery year / cash flow during recovery year]
What are the main drawback of the payback period? what is it good for?
does not take into account the time value of money or cash flows beyond the payback period.
Good for managing liquidity
What is the discounted payback period?
uses the present values of the projects estimates cash flows. it is the number of years it takes a project to recover initial investment at present value, and must be greater than the payback period without discounting.
What is the profitability index (PI)? What will the PI be if NPV is positive, negative?
is the present value of a project’s future cash flows divided by the initial cash outlay:
1 + NPV / CF0
if NPV is positive PI >1, if negative PI < 1
What is an NPV profile? What is the crossover rate?
it’s a graph that shows the NPV of a project over multiple discount rates
crossover rate is where the two NPVs of project intersect. Helpful in determining over what discount rate each project will be profitable.
What is the key advantage of NPV? main weakness?
direct measure of expected increase in value to the firm. main weakness is that it does not include any consideration of the size of the project.
What is a key advantage of IRR?
it measures profitability as a percentage, showing the return on each dollar invested. We can see how much below the IRR actual project return can fall before becoming uneconomic.
What are the disadvantages of the IRR method?
1) the possibility of producing rankings of mutually exclusive projects different from those from NPV analysis and
2) the possibility that a project has multiple IRRs or no IRR
