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What is the payback period?
The period of time necessary to recoup the cost an investment
What length of payback periods are preferred?
Shorter
In reference to the payback period, under what conditions is the project considered desirable?
If the payback period is less than or equal to the firm’s maximum desired payback period.
What is the payback period for the cash flows?
3.31 years
How do you calculate the payback period?
payback period = years + (unrecovered/free cash flow)
What is the payback period for the cash flows?
1.99 years
What are the benefits of payback periods?
Uses cash flows rather than accounting profits, easy to compute and understand, and useful for firms that have capital restraints
What are the drawbacks of payback periods?
Ignores time value of money and does not consider cash flows beyond the payback period
What is the solution to the payback periods lack of money time value?
Discounted Payback Periods
What is the Net Present Value?
It measures the net value of a project in today’s dollars.
What function (on financial calculator) do you use for net present values or profitability indexes?
The [CF] Function
What happens if any of the future free cash flows are cash outflows?
The future free cash flows take a negative sign.
If NPV>0, should you accept or reject?
Accept
If NPV<0, should you accept or reject?
Reject
How do you calculate NPV?
[CF]
[CF0] = initial investment (negative)
[CF1] = year 1
[CF2] = year 2
[CF…]
[NPV]
[I] = required return on investments
[NPV] [CPT]
What is the profitability index?
It provides a relative measure of the absolute dollar desirability of a project
How do you calculate profitability index?
(Present Value of all the future annual free cash flows)/(initial cash outlay) or (NPV+year 0)/(year 0)
Is PI>1, do you accept or reject?
Accept
Is PI<1, do you accept or reject?
Reject
How do you calculate IRR on a financial calculator?
Input cash flows in [CF], hit [IRR], [CPT]
If IRR>Required Return Rate, should you accept?
Yes, accept
If IRR<Required Return Rate, should you return?
No, reject
Calculate the IRR and whether it should be accepted if the RR is 13%.
IRR = 26.71%, yes accept.
What’s the main issue with IRRs?
Inconsistent cash flows, you’d have multiple IRRs.
What are mutually exclusive projects?
Two investments in which the acceptance of one automatically excludes the acceptance of another
When ranking mutually exclusive projects, how should payback period be decided on?
The shorter period the better
When ranking mutually exclusive projects, how should NPV be decided on?
The larger the better
When ranking mutually exclusive projects, how should IRR be decided on?
The larger the better
When ranking mutually exclusive projects, how should PI be decided on?
The larger the better
What is the deciding factor in most cases regarding mutually exclusive projects?
NPV. NPV IS KING.
Which project should you choose?
Project A. NPV is larger. NPV IS KING.
