chapter 8 Flashcards
(40 cards)
good decision criteria
- all cash flows considered
- risk-adjusted
- ability to rank projects
- indicates added value to firm
an investment is worth undertaking if
it creates value for its owners
if NPV is positive
accept the project
NPV is a direct measure of
how well this project will meet the goal of increasing shareholder wealth
NPV =
PV inflows - cost = net gain in shareholder wealth
NPV = 0
project’s inflows are exactly sufficient to repay the invested capital
payback period
how long it takes for an investment to generate cash flows sufficient to recover initial cost
decision rule (payback)
accept if payback period is less than some preset limit
payback advantages
easy to understand, adjusts for uncertainty of later cash flows, biased towards liquidity
payback disadvantages
- ignores time value of money
- requires arbitrary cut off point
- ignores cash flows beyond cutoff date
- biased against long-term projects
- doesn’t ask the right question
the simplicity of the payback rule is
an illusion
average accounting return (AAR)
an investment’s average net income divided by its average book value
average book value depends on
how the asset is depreciated
decision rule (AAR)
accept the project if the AAR is greater than the target rate
AAR advantages
easy to calculate, needed info usually available
AAR disadvantages
- not a true rate of return
- time value of money is ignored
- uses arbitrary benchmark cutoff rate
- based on accounting net income and book values, not cash flows and market values
most important alternative to NPV
internal rate of return
IRR is entirely based on
the estimated cash flows
IRR
discount rate that makes NPV = 0
decision rule (IRR)
accept the project if IRR is greater than the required return
IRR advantages
- preferred by executives
- intuitively appealing
- easy to communicate the value of a project
- if IRR is high enough, may not need to estimate a required return
- considers all cash flows and time value of money
- provides indication of risk
IRR disadvantages
- can produce multiple answers
- cannot rank mutually exclusive projects
- reinvestment assumption flawed
NPV and IRR will generally give the same decision except for
nonconventional cash flows, mutually exclusive projects
IRR and nonconventional cash flows
- cash flows change sign more than once
- most common: initial cost negative CF, stream of positive, negative to close
- nuclear power plant ex
