Chapter 8

Question 1

NPV

Answer 1

Net present value. the difference between and investment’s market value and its cost.

Question 2

DCF valuation

Answer 2

Discounted cash flow valuation.
a. calculating the present value of a future cash flow to determine its value today.
b. The process of valuing an investment by discounting its future cash flows.

Question 3

NPV rule

Answer 3

A investment should be accepted if the net present value is positive and rejected if it is negative

Question 4

Calculating next present value

Answer 4

present value of annuity-cost of investment

Question 5

Calculator buttons for NPV

Answer 5

CF
Enter, down arrow
NPV
CPT

Question 6

Payback loosely defined

Answer 6

the length of time it takes to recover our initional investment, or “get our bait back”

Question 7

Payback rule

Answer 7

An investment is acceptable if its calculated payback period is less than some specified number of years.

Question 8

Shortcomings of payback rule

Answer 8

1. Ignores time value of money
2. Calculated the same way for risky and safe projects
3. Arbitrary cutoff period
4. Will bias us toward shorter-term investments
5. Ignores cash flows beyond the cutoff date.

Question 9

Benefits of Payback Rule

Answer 9

1. Cheaper
2. Good for relatively minor decisions (investments less than $10,000)
3. Biased toward liquidity (good for small businesses)
4. Cash flows later in the project’s life are probably more uncertain.

Question 10

AAR

Answer 10

Average accounting return. An investment’s average net income divided by it average book value.

Question 11

AAR rule

Answer 11

A project is acceptable if its average accounting return exceeds a target average accounting return.

Question 12

Disadvantages of AAR rule

Answer 12

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.

Question 13

Advantages of AAR rule

Answer 13

1. Easy to calculate
2. Need information will usually be available.

Question 14

IRR

Answer 14

Internal rate of return. The discount rate that makes the net present value of an investment zero.

Question 15

IRR rule

Answer 15

An investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.

Question 16

another name for IRR

Answer 16

Discounted cash flow (DCF) return

Question 17

net present value profile

Answer 17

A graphical representation of the relationship between an investment’s net present value and various discount rates.

Question 18

Multiple rates of return

Answer 18

The possibility that more than one discount rate will make the net present value of an investment zero.

Question 19

What does it mean to say a project’s cash flows are conventional?

Answer 19

The first cash flow (the initial investment) is negative and all the rest are positive.

Question 20

When do problems with the IRR arise?

Answer 20

When cash flows are not conventional or when trying to compare two or more investments to see which is best.

Question 21

Two projects that are independent are…

Answer 21

not mutually exclusive
The cash flows of one project are unaffected by the acceptance of the other.

Question 22

Advantages of IRR

Answer 22

1. Easier to talk about/understand rate of return rather than net present value.
2. Closely related to NPV, often leading to identical decisions.

Question 23

Discounting approach for MIRR

Answer 23

Discount all negative cash flows back to present at the required return and add them to the initial cost. Then, calculate IRR.

Question 24

Reinvestment approach for MIRR

Answer 24

Compound all cash flows except the first out to the end of the projects life and then calculate the IRR.

Question 25

Combination approach for MIRR

Answer 25

Negative cash flows are discounted back tot he present, and positive cash flows are compounded to the end of the project.

Question 26

Which MIRR approach give the highest IRR?

Answer 26

The combination approach

Question 27

Problems with MIRR

Answer 27

1. Different ways of calculating them which no clear reason to say one is better than another. 2. Unclear how to interpret, don't use the project's actual cash flows. 3. If we have the relevant discount rate, why not calculate NPV. 4. Because it depends on an externally supplied discount (or compounding) rate, the answer you get is not truly and "internal" rat of return

Question 28

Advantage of MIRR

Answer 28

By design, they don't suffer from the multiple rate of return problem.

Question 29

PI

Answer 29

Profitability index or benefit-cost ratio. The present value of an investment's future cash flows divided by its initial cost.

Question 30

Advantages of PI

Answer 30

1. Closely related to NPV, generally leading to identical decisions. 2. Easy to understand and communicate. 3. May be useful when available investments funds are limited.

Question 31

Disadvantage of PI

Answer 31

May lead to incorrect decision in comparisons of mutually exclusive investments.

Question 32

Calculator buttons for IRR

Answer 32

Same as for NPV but IRR button instead of NPV button

Question 33

Calculator buttons for PI

Answer 33

Same as for NPV but put time CF0 to zero then take NPV divided by CF0

Question 34

When will IRR not reliably rank mutually exclusive projects?

Answer 34

1. When initial investments are substantially different. 2. When timing of cash flows is substantially different.