Finance CH8

Define NPV

PV of cash flows - initial investment

when do you accept NPV, and how do you rank it

when NPV > 0 ; NPV is ranked by highest for mutually exclusive projects

define IRR

Discount rate where NPV = 0

when do you accept IRR

Accept if IRR > cost of capital

If used correctly, IRR should match…

NPV.

you ___ rank mutually exclusive projects reliably

cannot

define PI (profitability index)

NPV / initial investment

When do you accept PI

Accept if PI > 0, rank highest PI under capital rationing

PI is useful for…

capital rationing ; same accept-reject as NPV

define Payback Period

time until cash flows = initial investment

when do you accept Payback Period

Accept if < cutoff

Payback period ignores…

cash flows after cutoff and discounting ; biased vs. long-term projects

define Discounted Payback

Time until PV of cash flows >= initial investment

when do you accept Discounted Payback

accept if < cutoff

Discounted payback never accepts ___ NPV

negative ; still ignores post-cutoff cash flows

what is the equation for EAA (equivalent annual annuity)

EAA = present value of costs / annuity factor

what is the equation for annuity factor

AF = (1-(1+r)^-n ) / r

what is EAA used for

to compare assets/machines of different lifespans. pick lowest EAA

define investment timing

choose project start date that maximizes NPV today. wait if expected gain from delay > cost of capital

define replacement problem

compare old machine annual cost vs. EAA of new machine (EAA (new) < cost(old)

what are the quick decision rules of NPV

always reliable; pick project with highest NPV

what are the quick decision rules of IRR

useful if no project interactions ; beware of multiple IRRS

what are the quick decision rules of PI

good for ranking under capital rationing

what are the quick decision rules of payback

rough guide; ignore post-cutoff cash flows

what are the quick decision rules of discounted payback

better than simple payback ; still ignores long-term cash flows

what are the quick decision rules of EAA

used to compare projects with different lives

a project’s opportunity cost of capital is…

the return that shareholders could expect to earn by investing in the financial markets

why would an investor select a project with lower NPV but higher profitability than a project with high NPV but lower profitability

capital rationing

define capital rationing

occurs when a company has limited funds to invest and cannot take all positive-NPV projects.

if a project’s NPV is calculated to be negative what should a project manager do

reject the project

if discount rate is greater than IRR, NPV is…

negative

if discount rate is less than IRR, NPV is…

positive

without capital rationing to choose between two mutually exclusive investments, what must be used

the NPV method.