Lecture 4 Flashcards
(26 cards)
Book rate of return =
Book income / book assets
Payback period
Number of years before cumulative cash flows equal initial outlay
Pay back rule
Only accept projects that pay back with in desired time frame
Payback period =
NO years of full recovery
+
uncovered cost / cash flow of last year before full payback
What does the payback rule ignore
The time value of money
Net present value of investment
Difference. Between the present value of its benefits and the required investment
NPV 0 =
C 0 + sum of C t / (1+r)^t
NPV rule
Managers increase shareholders wealth by accepting all projects with positive NPV
Mutually exclusive projects
Taking one. Investments makes the other redundant bc they both serve same purpose
What should you do when choosing between mutually exclusive projects
Choose on with highest NPV
IRR of a project ….
Is the discount rate that makes the projects NPV = 0
Opportunity cost of capital
Expected rate of return given up by investment in another project
IRR rule
Managers increase shareholders wealth by accepting all. Projects with IRR that is higher than the opportunity cost of capital (hurdle rate)
Calculating IRR
0= C 0+ sum of Ct/ (1+ IRR)^t
Trial and error
What do you do in the case of borrowing
Accept if IRR< the opportunity cost of capital
What happens to IRR when there are cash flows with multiple signs
More than 1 IRR
The more serious the capital rationing…
The more likely IRR will be used
Business had limited cash
What rule do they use
Then they’ll use IRR decision rule
If business has substantial funds
What rule do they use
NPV decision rule
What does profitability index do
Different scale investment comparable
Profitability index =
NPV / initial investment
Capital constraints causes you to do what
Pick combination of investments that yield highest NPV
What does high cash flow earlier mean
Hurt less by discounting
What does NPV assume
Cash flow gets reinvested at discount rate
