Lecture 4 Flashcards
(12 cards)
What is payback period?
The number of years it takes to recover initial investment through accumulated future cash flows
What are the advantages of payback?
- Easy to compute and understand so useful
- Encourages cash generation
- Values early cash flows over late cash flows
What are the disadvantages of cash flows?
- Adds cash flows ignoring the time value of money
- Choice of cut off period is arbitrary
- Ignores cash flows after cut off period
- Biased towards rejecting long - lived projects (possibly with positive NPVs)
- Biased towards accepting short-lived projects ) possible with negative NPVs)
What is a discounted payback period?
The number of years to recover initial investment considering time value of money
What is a positive of discounted payback period?
It solves time value issue
What is the internal rate of return (IRR)?
The discount rate that makes the NPV zero
What is a conventional investment project and the relation with IRR?
- Where there is an initial negative cash outflow followed by positive cash inflow
- Investors should accept project if IRR > Required rate of return (r*)
- IRR and NPV tell you the same thing about decisions on projects
What are the problems with IRR?
- IRR doesn’t work well with mutually exclusive projects (two projects that cannot be taken up at the same time)
What is ARR?
The ratio of the project’s average annual profits and the average annual book value of assets
What are the advantages of ARR?
- Easy to compute because the firm collects the accounting info anyways
What are the disadvantages of ARR?
- Ignores time value of money
- Choice of target ARR is arbitrary
- Based on earnings, not on cashflows
- No standard calculation method
- Not a true return on investment
What is PI (Profitbaility Index?)
- The ratio of the present value of future cash flows of a project and its initial invesment
- Accept a project if PI > 1
- PI doesn’t work well with mutually exclusive projects
