NPV & Other Investment Criteria Flashcards
(15 cards)
- What is the net present value rule?
The NPV rule states that an investment is acceptable if its Net Present Value (NPV) is positive—meaning the present value of future cash flows exceeds the initial cost. It represents the value created for shareholders.
- If we say an investment has an NPV of $1,000, what exactly do we mean?
It means the investment is expected to generate $1,000 in value above its cost, after discounting all cash flows. This $1,000 is additional wealth for shareholders.
- In words, what is the payback period? The payback rule?
The payback period is how long it takes for an investment’s cash flows to recover the initial investment cost. The payback rule states that an investment is acceptable if its payback period is less than a prespecified number of years.
- Why do we say that the payback period is, in a sense, an accounting break-even measure?
Because it tells us when the cumulative cash flows equal the initial investment, much like break-even in accounting where revenues cover costs, but without accounting for time value of money (TVM).
- What is the discounted payback period?
It is the time it takes for the present value of cash flows to equal or exceed the initial investment. It improves the regular payback by accounting for TVM.
- Why do we say it is a financial or economic break-even measure?
Because it considers the time value of money, making it a more realistic measure of when the investment starts adding economic value.
- What advantages does the discounted payback rule have over the ordinary payback rule?
Accounts for time value of money
Better reflects economic reality
More accurate in comparing projects of different timing and risk
- What is an average accounting rate of return (AAR)?
AAR = Average Net Income / Average Book Value
The rule: Accept a project if AAR exceeds a target accounting return.
- What are the weaknesses of the AAR rule?
Ignores time value of money
Relies on arbitrary cutoffs
Based on accounting data, not cash flows
Doesn’t reflect the actual financial profitability
- When do IRR and NPV rules give the same decision? When might they conflict?
They give the same decision if:
Cash flows are conventional (initial outflow followed by inflows)
Projects are independent
They may conflict if:
Cash flows are non-conventional
Projects are mutually exclusive
- Is it true that an advantage of IRR is that we don’t need to know the required return?
Yes, IRR is calculated independently of the required return, but to make a decision, we still need to compare it to the required return.
- What does the profitability index measure?
It measures value created per dollar invested, calculated as:
PI = PV of Future Cash Flows / Initial Investment
- How would you state the profitability index rule?
If PI > 1, accept the project.
If PI < 1, reject the project.
(PI > 1 implies positive NPV)
- What are the most commonly used capital budgeting procedures?
Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback Period
Discounted Payback
Average Accounting Return (AAR)
Profitability Index (PI)
- If NPV is conceptually best, why use other measures?
NPV requires precise estimates and discount rate
Other methods are simpler, faster, and easier to explain
Useful for quick checks or supporting decisions
Different measures offer complementary insights (e.g., liquidity from payback, accounting impact from AAR)
