Business Finance Chapter 9 Notes

Business Finance Chapter 9 Notes Capital budgeting is the decision-making process for accepting and rejecting projects. In capital budgeting, the net present value determines the value of a project to the company. A project should be accepted if its NPV is greater than zero. NPV discounts cash flows properly. The amount of time needed for the cash flows from an investment to pay for its initial cost is the payback period. 6. Using the payback period rule will bias toward accepting which type of investment? Short-term investment 7. Net present value is a measure of how much value is created or added today by undertaking an investment. 8. This capital budgeting method allows lower management to make smaller, everyday financial decisions effectively. Payback method 9. The basic NPV investment rule is: a. if the NPV is equal to zero, acceptance or rejection of the project is a matter of indifference b. reject a project if its NPV is less than zero. c. accept a project if the NPV is greater than zero. 10. The payback method differs from NPV because it evaluates a project by determining the time needed to recoup the initial investment. 11. The three attributes of NPV are that it: a. discounts the cash flows properly. b. uses cash flows. c. uses all the cash flows of a project. 12. The payback period rule suggests accepting a project if it has a payback period that is less than or equal to a particular cutoff date. 13. Arrange the steps involved in the discounted payback period in order starting with the first step. a. #1 – Discount the cash flows using the discount rate. b. #2 – Add the discounted cash flows c. #3 – Accept the discounted payback period is less than some prespecified number of years. 14. By ignoring time value, the payback period rule may incorrectly accept projects with negative NPV. 15. The payback period method allows lower management to make smaller, everyday financial decisions effectively. 16. Which of the following are weaknesses of the payback method? a. Cash flows received after the payback period are ignored. b. The cutoff date is arbitrary. c. Time value of money principles are ignored. 17. Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified number of years. 18. Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period? Discounted payback period 19. The discounted payback is the time it takes to break even in economic or financial sense. 20. The AAR is calculated by taking the average net income and dividing it by the average book value. 1. 2. 3. 4. 5. 21. Based on the average accounting return rule, a project is acceptable if its average accounting return exceeds a target or goal average accounting return. 22. One of the weaknesses of the payback period is that the cutoff date is an arbitrary standard. 23. Capital Corp is considering a project whose internal rate of return is 14%. If Capital's required return is 14%, the project's NPV is: zero (0) 24. True: Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified number of years. 25. According to the basic IRR rule, we should reject a project if the IRR is less than the required return. 26. Payback period tells the time it takes to break even in an accounting sense. Discounted payback period tells the time it takes to break even in an economic or financial sense. 27. According to the average accounting return rule, a project is acceptable if its average accounting return exceeds: a target average accounting return. 28. Based on the average accounting return rule, a project is acceptable if its average accounting return exceeds a target average accounting return. 29. For a project with conventional cash flows, the NPV is positive if the required return is less than the IRR, and it is negative if the required return is greater than the IRR. 30. The point at which the NPV profile crosses the horizontal axis is the: internal rate of return (IRR). 31. The point at which the NPV profile crosses the vertical axis is the: sum of the cash flows of the project. 32. If the IRR is greater than the required return, we should accept the project. 33. The IRR rule can lead to bad decisions when cash flows are not conventional or projects are mutually exclusive. 34. With nonconventional cash flows, there is a possibility that more than one discount rate will make the NPV of an investment zero. This is called the multiple rates of return problem. 35. The IRR is the discount rate that makes the NPV of a project equal to zero. 36. A situation in which taking one investment prevents the taking of another is called a mutually exclusive investment decision. 37. The IRR rule can lead to bad decisions when projects are mutually exclusive or cash flows are not conventional. 38. True: The crossover rate is the rate at which the NPVs of two projects are equal. 39. True: Some projects, such as mines, have cash outflows followed by cash inflows, which are then followed by cash outflows, giving the project multiple rates of return. 40. True: IRR approach may lead to incorrect decisions in comparison of two mutually exclusive projects. 41. If a project has multiple internal rates of return, which of the following methods should be used? a. MIRR b. NPV 42. Which of the following are mutually exclusive investments? a. Two different choices for the assembly lines that will make the same product. b. A restaurant or a gas station on the same piece of land. 43. The present value of all cash flows (after the initial investment) is divided by the initial investment to calculate the profitability index. 44. False: The MIRR function eliminates multiple IRRs and should replace NPV. Reason: NPV is more versatile and also eliminates multiple rates of return. 45. The profitability index is calculated by dividing the PV of the future cash flows by the initial investment. 46. The Average Accounting Return (AAR) Rule states that a company will accept a project that has an average account return that: exceeds a pre-determined target average accounting return. 47. According to the video, which of the following are disadvantages of the Average Accounting Return (AAR)? Time value of money is ignored and Market values are not considered. 48. What is the first step when calculating the crossover rate? To calculate the cash flow differences between each project. 50. What is crossover rate? The discount rate at which we are indifferent between two investments. 51. The Discounted Payback Period Rule states that a company will accept a project if: The calculated payback is less than a pre-specified number of years. 52. All of the following are disadvantages of the Payback Period, except: The method incorporates the time value of money. 54. The Internal Rate of Return (IRR) represents which of the following: The discount rate that makes the net present value equal to zero. 56. What are non-conventional cash flows? A combination of cash outflows and inflows. 58. All of the following are commonly cited reasons for using the Internal Rate of Return, except: 59. Multiple IRR’s allow the company to choose the best one when evaluating projects. 61. What does the Modified Internal Rate of Return (MIRR) assume? The MIRR assumes that cash flows will be reinvested at the cost of capital. 63. The combination approach for calculating the Modified Internal Rate of Return (MIRR) differs because: Negative cash flows are discounted back and positive cash flows are compounded forward. 64. What does mutually exclusive mean? Top of Form 65. When choosing between mutually exclusive projects, what is the best method to use? The highest NPV is always the best option. 66. What is the first step in the Net Present Value (NPV) process? Estimate the future cash flows. 67. According the video, one of the biggest challenges for the Net Present Value method is: a. Time value of money is ignored. b. An arbitrary benchmark cutoff rate is established. c. Market values are not considered. 68. The Payback Period Rule states that a company will accept a project if: The calculated payback is less than a pre-specified number of years. 69. All of the following are disadvantages of the Payback Period, except: The method incorporates the time value of money. 70. All of the following are advantages of the Profitability Index, except: It is useful for comparing mutually exclusive investments. 71. All of the following are useful for understanding Profitability Index, except: The initial investment is included when calculating the present value of the future cash flows.