Ch 9-NPV

Question 1

WHAT IS NPV

Answer 1

difference between investment market value and investment cost

it is a measure of how much value is cerated or added by undertaking an investmetn

Question 2

what is capital budgeting all about

Answer 2

determining whether an investment is worthwile

Question 3

capital budgeting and npv relationship

Answer 3

capital budgeting is looking for investments with positive npvs

Question 4

when do we have to estimate npv

Answer 4

when there is no market to compare to (no housing market to compare house prices with etc)

Question 5

how do we estimat npvs?

Answer 5

• estimate the future cash flows that we expect to recieve “discounted cash flow valuation”

Question 6

if the NPV is negative, the effect on share value would be
unfavourable. If the NPV is positive, the effect would be favourable.

Question 7

if npv posititve: accept
if npv negative: reject

Question 8

how to do a basic discounted cf valuation?

Answer 8

1. draw a number line, and write out the cash inflow from each year
2. discount them all to year one using number line method if varying cf, or the pv annuity formula if constant cf
3. compare to cost
4. if cost> cf= -npv
   if cost < cf= + npv

Question 9

Payback meaning

Answer 9

the legnth of time it takes to recover og investment

How many years do we have
to wait until the accumulated cash flows from this investment equal or exceed the cost of the investment?

HOW LONG TILL WE BREAK EVEN

Question 10

IF an investment pays itself back in 2 years what is the payback period

Answer 10

2 years

Question 11

payback period rule

Answer 11

an investment is acceptable is payback is less than x amount of years

Question 12

shortcomings of payback period rule

Answer 12

• no objective basis to choose the x amount of years
• no discounting involved so tvm is ignord
• doesnt consider risk differences (payback would be the same for risk and non risk prohects)
• requires arbitarry cutoff point and ignroes cash flows beyond the cutoff point

Question 13

using a payback period rule tends to bias us toward shorter-term investments

Question 14

pros of payback rule

Answer 14

• good for ppl w no knowledge
• used whwen cost of doing analysis is extra
• it is good for general rules: like all investments less than 10k should have a 2 year payback
• biased to liquidity

Question 15

payback rule is biased towards short term projects, what does this imply?

Answer 15

it is biased towards liquidity!!!

and arguably it takes into account the risk of long term projects because only the more recent ones are guaranteed!!

Question 16

. Because time value is ignored, you
can think of the payback period as the length of time it takes to break even in an accounting sense, but not
in an economic sense

Question 17

discounted payback rule: modified payback rule

Answer 17

an inveestment is acceptable if its discounted payback is less than x amount of years

Question 18

how to apply discounted payback rule?

Answer 18

1. discount each years cash flow back
2. create a new column called accuulated cash flow and add them up
3. see when you have pacyback total

yr|cf(undisc)|cf(disc)|accf|(undisc)|acccf(disc)

Question 19

payback rule

discounted payback rule

Answer 19

tells u when u break even accounting wise

tells u when u break even economic/financial wise

Question 20

discounted payback is a compromise between a regular payback and NPV that
lacks the simplicity of the first and the conceptual rigour of the second

Question 21

average accounting return

Answer 21

some measure of average acct proft/ some measure of avg acct value

Question 22

AAR= average net income/ average book value

Answer 22

Based on the average accounting return rule, a project is acceptable if its average accounting return
exceeds a target average accounting return

Question 23

cons of aar method

Answer 23

• not a rate of return in any meaningful sense
• it is the ratio of two acct numbers

-ignores tvm
- arbitrary way of choosing target AAR
- doesnt look at the right things (no focus on cash flow and market value, uses net income and book value)

Question 24

pros ofAAR

Answer 24

EASY TO CALCULATE
required info is usually available

Question 25

IRR

Answer 25

internal rate of return- single rate summarizing merits of a project internal: focused only on the cf of a given investment no external rates

Question 26

Based on the IRR rule, an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.

Question 27

link between IRR nad NPV

Answer 27

IRR is the rate that results in NPV being 0 when IRR=r

Question 28

net present value profile.

Answer 28

the graph shows how NPV changes as the discount rate used changes. when the npv is above x axis, it is all the discount rates wehre npv is positive when the npv is below x axis it is all the discount rate where npv is negative when npv crosses x axis it is the IRR

Question 29

DOES npv and irr always give the same decisions?

Answer 29

only if: 1. projects cash flow are conentional (first cf is negative) and the rest are positive 2. project is independant and unrelated to other

Question 30

non conventional cash flows: when signs change more than once

Answer 30

This is because the NPV curve crosses the x axis twice=-> there are two IRRs when more than one sign change: there are multiple rates of return basically this happens when tehre is an initial negative outlay (cost to start up) and also negative outlay at the end USE NPV RULE

Question 31

irr problems

Answer 31

#1 two sign changes #2 mutually exclusive investment decisions

Question 32

irr problem- mutually exclusive investment decisions

Answer 32

if u have two investments and u can only pick 1, you would pick th eone with the highest npv always, but NOT ALWAYS THE ONE WITH THE HIGHER IRR any time we are comparing investments to determine which is best, IRRs can be misleading

Question 33

MUTUALLY EXCLUSIVE INVESTMENTS- CROS SOVER RATE + HOW TO FIND IT

Answer 33

crossover rate= the discount rate that makes the npvs of both project equal method #1: too calculate: compute IRR on the difference of the cash flows 1. set up a new column (inv a-inv b) 2. if the sign changes only once then calculate IRR!!! 3. you can figure out where IRR is by using the IRR funciton method #2: NPV(B-A) = -(extra money to invest in B) + (extra cf in b year 1)/1+r + (extra cf in b year 2)/(1+r)^2 set NPV(B-A)= 0 solve for IRR

Question 34

why do people choose IRR

Answer 34

- people like talking about rates of return - easy to get

Question 35

cons of IRR

Answer 35

may result in mulitple answers/no answers with non conventional cf may lead to incorrect decisions when comparing mutually exclusive investments

Question 36

profitiability index= beneft/cost ratio

Answer 36

PV of future cf/ initial investment

Question 37

pros and cons of profitbaility index

Answer 37

pros: -similar to NPV, has same diecisions usually -easy to get - useful when avialble investment funds are limited cons: - may lead to wrong decision in comparing mutually exlcusive investments

Question 38

6 ways to do capital budgting6

Answer 38

1. npv 2. irr 3. payback epriod 4. discounte payback 5. arr 6. profitbaility index

Question 39

capitol rationing

Answer 39

complication in capital budgeting! exsits when profitable (positive NPV) BUT we dont have the money to invest so we do capital rationing

Question 40

soft rationing

Answer 40

when business units have x fixed amount of money every year company as awhole isnt short on capitol, and more can be raised! if this is a once in a while problem, try to choose projects with biggest NPV and highest PI index! if this is achronic porblme something is up

Question 41

HARD rationing

Answer 41

company as a whole is short on money and cant raise any money under any circumstances DCF analysis breaks down and no best course of action; if our requried rate of return is 20%, we usually take projects with greater return but if we have hard dationing we cant take any porjcets!!!

Question 42

AAR formula

Answer 42

AVERAGE NET INCOME/ AVERAGE BOOK VALUE AVERAGE BOOK VALUE depends on how an asset is depreciated

Question 43

Modified IRR

Answer 43

3 methods: 1) DISCOUNTING APPROACH: - discount all negative cf back to the present at the required return -add them to the inital cost :::::move all the negative cf to Y0 2) REINVESTMENT APPROACH: -compound all cash flows (+ and -) except the first out to the end and then calc IRR - CALCULATE THE FV ::::: move all the positive cf to Ylast 3) COMBO APPROACH: -negative cf discounted to the present and positive cash flows are compounded to the end ::::move all the negative cf to Y0 and move all the positive cf to Ylast

Question 44

MIRRs and IRR

Answer 44

- TOUGH bc diff ways to calculate IRR and no one knows which is better -ALSO you use an external rate which is no longer internal!!!