FINA Quiz #3 (Chapters 8,9,12,10)

If NPV is positive…

Accept the project

Accept Payback Period…

If it’s less than some preset limit

Advantages of Payback Period

1. Easy to understand.

2. Adjusts for uncertainty of
   later cash flows

3. Biased towards liquidity.

Disadvantages of Payback Period

• Ignores the time value of money.

• Requires an arbitrary cutoff point.

• Ignores cash flows beyond the cutoff date.

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

Accept IRR if…

Greater than required return

IRR Advantages

1. Intuitively appealing.

2. Easy to communicate the value of a project.

IRR Disadvantages

Produces multiple answers

Cannot rank mutually exclusive projects

Reinvestment Assumption flawed

Independent Projects

The cash flows of one project are unaffected by the acceptance of the other.

Mutually Exclusive Projects

The acceptance of one project precludes accepting the other.

If Profitability Index is greater than 1…

Accept the project

Profitability Index Advantages

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

• Considers all CFs

• Considers TVM

• Easy to understand and communicate

• Useful in capital rationing

Disadvantages of Profitability Index

May lead to incorrect decisions in comparisons of mutually exclusive investments (can conflict with NPV).

Incremental Cash Flows

The increase in cash that the addition of a specific new project generates above the current cash flow

Stand Alone Principal

allows us to analyze each project in isolation from the firm by focusing on incremental cash flows

Advantages of Dividend Growth Model

Easy to understand and use

Disadvantages of Dividend Growth Model

1. Only applicable to companies currently paying dividends.

2. Not applicable if dividends aren’t growing at a reasonably
constant rate.

3. Extremely sensitive to the estimated growth rate.

4. Does not explicitly consider risk.

Advantages of SML

Explicitly adjusts for systematic risk.

Applicable to all companies, as long as beta is available.

Disadvantages of SML

• Must estimate the expected market risk premium, which does vary over time.

• Must estimate beta, which also varies over time.

• Relies on the past to predict the future, which is not always reliable

Erosion Costs

Costs that arise when a new product or service competes with revenue generated by a current product or service offered by a firm.

Salvage Value

The market price you sell the asset for

SV > BV

Must pay taxes on profit

SV < BV

You don’t pay taxes