MGT 181 chapter 9

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15 Terms

1

Net Present Value (NPV)

The difference between the market value of a project and its cost

  • if NPV > 0, Accept project

  • If NPV < 0, reject project

  • If NPV = 0, indifferent

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2

Steps for finding NPV

Step 1: estimate the expected future cash flows

Step 2: estimate the required return for projects of this level

Step 3: find the present value of the cash flows and subtract the initial investment

This is the value added

NPV = -(initial cost) + cash flow/(1 + wacc) + cash flow/(1+ wacc) …

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3

Payback period

How long it takes to get the initial cost back in a nominal sense

  • usually used by smaller firms

Accept if the payback period is less than some present limit

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4

How to find Payback period

Step 1: estimate cash flows

Step 2: subtract the future cash flows from the initial cost until the initial investment has been recovered

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5

Advantages of payback period

  • easy to understand

  • adjusts for uncertainty of later cash flows

  • biased toward liquidity

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6

Disadvantages of Payback Period

  • ignores the time value of money

  • requires an arbitrary cut off point

  • ignores cash flows beyond the cut off date

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

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Discounted payback Period

  • compute the present value of each cash flow and then determine how long it takes to pay back on a discounted basis

  • compare to a specific required period

  • Accept the project if it pays back on a discounted basis within the specified time

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8

Advantages of Discounted Payback Period

  • includes time value of money

  • easy to understand

  • does not accept negative estimated NPV investments when all future cash flows are positive

  • Biased towards liquidity

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9

Disadvantages for Discounted PayBack Period

  • may reject positive NPV investments

  • Requires an arbitrary cutoff point

  • Ignores cash flows beyond the cutoff point

  • biased against long-term projects, such as R&D and new products

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10

Internal Rate of Return

  • most important alternative to NPV

  • a single rate of return that summarizes the merits of a project

  • IRR is the return that makes NPV=0

  • Accept the project if IRR > the required rate of return

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11

NPV vs IRR

Whenever there is a conflict between NPV and another decision rule, always use NPV

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12

Profitability Index

  • present value of an investment’s future cash flows divided by its initial cost

  • Measures the benefit per unit cost, based on the time value of money

  • This measure can be very useful in situations in which we have limited capital

    = PV of cashflows / cost

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Advantages of Profitability Index

  • closely related to NPV, generally leading to identical decisions

  • easy to understand and communicate

  • may be useful when available investment funds are limited

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14

Disadvantages of Profitability Index

  • may lead to incorrect decisions in comparisons of mutually exclusive investments

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15

Evidence from the Field

  • large firms are more likely to use NPV than small firms

  • Small firms with CEOs (with longer tenure) without MBAs are more likely to use Payback criteria

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