Fin 300 Ch 9

Front 1

What are the most frequently used capital budgeting techniques for large firms?

Back 1

IRR and NPV

Front 2

NPV=

Back 2

PV(benefits)-PV(costs)

Front 3

NPV decision rule

Back 3

Accept positive NPV projects and reject negative NPV projects

Front 4

Why is NPV rule the BEST? (3)

Back 4

1. NPV uses cash flows instead of earnings

2. NPV uses all relevant cash flows of the project

3. NPV recognizes the magnitude, risk, and timing of cash flows

ALWAYS go with NPV over other capital budgeting techniques

Front 5

Payback Period decision rule

Back 5

Accept if the payback period is less than the cutoff time

Front 6

Advantages of Payback (3)

Back 6

1. Easy to understand

2. Adjusts for uncertainty of later cash flows

3. Biased toward liquidity

Front 7

Disadvantages of Payback (4)

Back 7

1. Ignores the time value of money

2. Requires an arbitrary cutoff point

3. Ignores cash flows beyond the cutoff date

4. Biased against long-term projects, such as research and development, and new projects

Front 8

Discounted Payback Period decision rule

Back 8

Accept the project if it pays back on a discounted basis with the cutoff time

Front 9

Discounted Payback Period

Back 9

Tells us how long does it take to get the initial investment back based on the present (or discounted) value of each cash flow

Front 10

Advantages of Discounted Payback (4)

Back 10

1. Includes the time value of money

2. Easy to understand

3. Does not accept negative estimated NPV investments when all future cash flows are positive

4. Biased towards liquidity

Front 11

Disadvantages of Discounted Payback (4)

Back 11

1. May reject positive NPV investments

2. Requires an arbitrary cutoff point

3. Ignores cash flows beyond the cutoff point

4. Biased against long-term projects, such as R&D and new products

Front 12

Average Accounting Return (AAR)

Back 12

Book definition: average net income/average book value

Front 13

AAR decision rule

Back 13

Accept the project if the AAR is greater than a preset return

Front 14

Advantages of ARR (2)

Back 14

1. Easy to calculate

2. Needed information is readily available in accounting statements

Front 15

Disadvantages of ARR (3)

Back 15

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

Front 16

Internal Rate of Return (IRR)

Back 16

Most important and most popular alternative to NPV

IRR is the return that makes the NPV = 0

Front 17

IRR decision rule

Back 17

Accept the project if the IRR is greater than the required return (i.e. cost of capital) on the project

Front 18

IRR Advantages

Back 18

1. One of the most commonly used approaches by large firms

2. Knowing a return is intuitively appealing

3. It is a simple way to communicate the value of a project for someone who does not know the details

One fallacy: to apply the IRR rule, you need a benchmark required return

Front 19

Multiple IRRs

Back 19

Multiple IRRs exist because the cash flows of the project change signs more than once (from positive to negative and vice versa)

There can be as many IRRs as the times cash flows change signs over time

Front 20

Problems with IRR when selecting mutually exclusive projects

Back 20

1. Initial investments are substantially different (issue of scale)

2. Timing of cash flows is substantially different.

Front 21

Should you use the IRR rule when there are more than one IRR?

Back 21

NO (i.e. do not use IRR if there is more than one change from positive to negative or back)

Front 22

Modified IRR (MIRR)

Back 22

Single answer with MIRR which eliminates the multiple IRR problem

Limited use in practice because it is hard to interpret due to modified cash flows

Do NOT need to know how to calculate

Front 23

Profitability Index

Back 23

PI is a way of applying the NPV rule given resource constraint. Rank by PI and take the highest PI projects until the resource is exhausted.

Accept if PI>1 for independent projects.

Front 24

Advantages of PI (3)

Back 24

1. Closely related to NPV, generally leading to identical decisions

2. Easy to understand and communicate

3. May be useful when available investment funds are limited

Front 25

Disadvantages of PI (1)

Back 25

May lead to incorrect decisions in comparisons of mutually exclusive investments

Front 26

Two options for investments of unequal lives

Back 26

1. Replacement chain

2. The Equivalent Annual Cost (EAC) Method

Front 27

Equivalent Annual Cost Method decision rule

Back 27

Select the choice with the lower cost