Chapter 8 Flashcards
(26 cards)
The payback period is the length of time it takes an investment to generate sufficient cash flows to enable the project to…
Recoup its initial cost
The payback period measures the time required to recover an investment’s initial outlay.
What is the internal rate of return (IRR) of an investment project?
The discount rate that results in a zero net present value for the project.
IRR is a key metric in capital budgeting that helps assess the profitability of potential investments.
Both Projects A and B are acceptable as independent projects. However, the selection of either one of these projects eliminates the option of selecting the other project. Which one of the following terms best describes the relationship between Project A and Project B?
Mutually exclusive.
This means choosing one project prevents the selection of the other.
What can be defined as a benefit-cost ratio?
Profitability index.
The profitability index is calculated by dividing the present value of future cash flows by the initial investment.
What indicates that a project is expected to create value for its owners?
Positive net present value.
A positive NPV means the project’s return exceeds the cost of capital.
If an investment’s return is equal to the required return, what will its net present value be?
Zero.
An NPV of zero indicates the investment is expected to break even.
What indicates that a project should be rejected?
Profitability index less than 1.0.
A profitability index below 1.0 suggests that the costs outweigh the benefits.
What is the primary advantage of payback analysis?
Ease of use.
Payback analysis is straightforward but has limitations regarding the time value of money.
Which method of analysis ignores the time value of money?
Payback.
The payback method does not account for the timing of cash flows.
Which method of analysis has the greatest bias toward short-term projects?
Payback.
This method favors quicker returns over long-term profitability.
What does the modified internal rate of return address?
Unconventional cash flows.
This method is designed to provide a more accurate reflection of a project’s profitability when cash flows change signs.
Which analysis method is most appropriate for mutually exclusive investments?
Net present value.
NPV is preferred as it provides a direct measure of value addition.
Jen has just been asked to analyze an investment to determine if it is acceptable. Unfortunately, she is not being given sufficient time to analyze the project using various methods. She must select one method of analysis and provide an answer based solely on that method. Which method do you suggest she use in this situation?
Net present value
This method allows for rapid assessment without extensive calculations.
Which financial method provides information on expected dollar return per dollar spent?
Profitability index.
The profitability index indicates how much value is created per unit of investment.
ABC is considering a project with an initial cost of $53,200, and cash flows of $19,600, $22,000, $38,000, and −$13,200 for Years 1 to 4, respectively. How many internal rates of return do you expect this project to have?
2 (*NOTE: sign of cash flows changes twice 1st: -53200 to 19600; 2nd 38000 to -13200)
Multiple IRRs occur when cash flow signs change more than once.
What conclusion can be drawn if a firm accepts a positive net present value project?
The stockholders’ value in the firm is expected to increase.
A positive NPV typically indicates that the project will add value to the firm.
The net present value method of capital budgeting analysis does all of the following except…
Provide a specific anticipated rate of return
NPV considers the risk associated with future cash flows by discounting them.
A conventional investment project should be accepted if the IRR is:
Equal to or greater than the discount rate.
This indicates that the project meets or exceeds the minimum required return.
How is the internal rate of return for a capital project best defined?
The discount rate that causes the net present value to equal zero.
IRR is a critical measure for evaluating the profitability of a project.
When will a project have more than one IRR?
When the cash flow pattern exhibits more than one sign change.
Projects with alternating cash flows can produce multiple IRRs.
What bias does the payback method of analysis have?
Timing bias.
The payback method favors earlier cash flows, potentially undervaluing later benefits.
A firm more concerned with quickly recovering its initial investment will likely use the ________ method.
payback.
This method emphasizes speed of recovery over total profitability.
An investment is acceptable if the payback period:
is less than some pre-specified period of time.
A shorter payback period is generally preferred.
An independent investment is acceptable if the profitability index (PI) is:
greater than 1.0.
A PI greater than 1 indicates that the investment generates more value than its cost.
