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38 Cards in this Set
- Front
- Back
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What is net present value? |
The difference between the cost of the investment and the future cash flows |
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What Is the minimum acceptance criteria of NPV? |
Accept if NPV>0 |
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How do you rank compared NPV's? |
Highest NPV first |
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What are 2 reasons to use NPV? |
1) uses all relevant cash flows 2) discounts the cash flows properly |
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In NPV, what is the reinvestment assumption? |
That all cash flows can be reinvested at the discount rate |
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What Is the minimum acceptance criteria for the payback period method? |
Set by management |
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What is the ranking criteria for the payback period method? |
Set by management, often the shortest payback period is preferred |
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What are 2 advantages of using the payback period method? |
1) easy to understand 2) biased towards liquidity |
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What are 5 disadvantages of the payback period method? |
1) ignores the time value of money 2) ignores cash flow after payback period 3) biased against long-term projects 4) requires an arbitrary acceptance criteria 5) good payback period doesn't mean positive NPV |
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What is the difference between the discounted payback period and the payback period? |
The discounted payback period method takes the time value of money into account |
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How do you calculate AAR? |
Average net income ÷ average book value of investment |
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What does AAR stand for? |
Average accounting return |
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What is the minimum acceptance criteria for AAR? |
Set by management |
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What is the ranking criteria for AAR? |
Set by management |
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What are 2 advantages of AAR? |
1) information usually available 2) easy to calculate |
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What are 3 disadvantages of AAR? |
1) ignores the time value of money 2) uses an arbitrary benchmark cut off rate 3) based on book values, not cash flows and market values |
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What is the internal rate of return? |
The discount rate that sets the NPV to zero |
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What does IRR stand for? |
Internal rate of return |
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What is the minimum acceptance criteria for IRR? |
If IRR exceeds the required return (NPV will be positive) |
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What is the ranking criteria of IRR? |
Select alternative with the highest IRR |
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What is the reinvestment assumption when using IRR? |
All future cash flows assumed reinvested at the IRR |
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What is 1 advantage of using the IRR? |
Easy to understand and communicate |
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What are 3 disadvantages of using IRR? |
1) doesn't distinguish between investing and borrowing 2) IRR may not exist, or there may be multiple IRRs 3) problems with mutually exclusive investments |
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What does it mean to have mutually exclusive projects? |
Only ONE of several potential projects can be chosen |
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What does it mean to have independent projects? |
Accepting or rejecting one project does not affect the decision of the other projects |
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What does it mean to have independent projects? |
Accepting or rejecting one project does not affect the decision of the other projects |
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What are the 3 steps to calculating modified IRR? |
1) calculate NPV of all cash outflows using the borrowing rate 2) calculate the NFV of all cash inflows using the investing rate 3) then find the rate of return that equates these values |
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What are 2 advantages of using modified IRR? |
1) single answer 2) specific rates |
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What is the scaling problem with IRR? |
IRR ignores the problem of scale in case of a mutually exclusive investment decision |
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What is the timing problem with IRR? |
Doesn't take into account when certain cash flows occur |
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What are 2 situation when NPV and IRR won't give the same decision? |
1) non-conventional cash flows (cash flow signs change more than once) 2) mutually exclusive projects |
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How do you calculate PI? |
Total PV of future cash flows ÷ initial investment |
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What does PI stand for? |
Profitability index |
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What is the minimum acceptance criteria of PI? |
Accept if PI>1 |
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Whatvis the ranking criteria of PI? |
Select alternative with highest PI |
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What are 3 advantages of PI? |
1) useful when investment funds are limited 2) easy to understand and communicate 3) correct decision when evaluating independent projects |
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What's a disadvantage of using PI? |
Problems with mutually exclusive investments |
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What are the 2 most frequently used capital budgeting methods? |
IRR or NPV |
