Finance Test 3
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Define Net Present Value
The most important decision tool. It is the differnce between the market value of a project and its cost
How to calcualte Net Present Value?
- First, estimate the expectecd future cash flow,
- Second, extimate the required return for projects of this risk level
- Third, find the prsent value of the cash flows and subtract the initial investment
What is te NPV Decision Rule?
- If the NPV is positive, accept the project.
- A positve NPV meas that the project is expected to add value to the firm and will therefore increase the wealth of the owners.
- Our goal is to increase owner wealty, NPV is the direct measure of how well tis project will meet that goal
Define the Payback Rule
To accept project if the payback period is less than some preset limit
Decision Criteria Test- Payback
Payback Rule does NOT: account for the time value of money, account for the risk of the cash flows, provide an indication about te increase in value. We should not consider the payback rule for our primary decision rule.
Advantages of Payback
- Easy to understand
- Adjusts for uncertainty of later cash flows
- Biased toward liquidity
Define Discounted Payback
Compute the present value of each cash flows and then determine ow long it takes to pay back on a discounted basis.
Discounted payment decision rule
Accept the project if it pays back on a discounted basis within the specified time
Decision Criteria Test - Discounted Payback
Discounted payback does account for the time value of money, and account for the risk of the cash flows. It does not provide an indication about the increase in value. We should not consider the discounted payback rule for our primary decisions.
Define the Average accounting Return
- Average net income / Average book value,
- Need to have a target cutoff rate
Average Accounting Return Rule
Accept the project if the AAR is greater than a present rate
Advanrages of AAR
- easy to calculate
- needed information will usually be avialable
Disadvanrages of AAR
- Not a true rate of return; time value of money is ignored
- Uses an arbitrary benchmark cutoff rate
- Based on accounting net income and book values, not cash flows and market values
Define the Internal Rate of Return
- This is the most important alternative to NPV
- It is based entirely on the estimated cash flows and is intedepended of interst rates found else ware.
- IIR is the return that makes the NPV=0
IRR Decision Rule
Accept the project if te IRR is greater tan the required return
Decision Criteria Test - IRR
The IRR rule accounts for the time value of money and the risk of the cash flows. It does not necessarily provide an indication about the increase in value it is used to validate NPV. We should not consider te IRR rule for our primary decision criteria
Advanrages of IRR
- Knowing a return is inituitively appealing
- it is simple way to communicate the value of a project to someone wo doesn't know all the estimation details
- If the IRR is high enough, you may not need to estimate a required return, wich is often a difficult task
What questions must we ask ourselves when evaluating capital budging decision rules?
- Does the decision rule adjust for the time value of money?
- Does the decision rule adjust for risk?
- Does the decision rule provide information on wheather we re creating value for the firm?
Relevant Cash Flows
- The cashflows that should be included in a capital budgeting analysis are those tat will only occur (or not occur) if the project is accepted
- These cash flows are called incremental cash flows
cost that have accrued in te past
cost of lost options
Side effects, decirbe postive and negative
- postive - benefits to other projects
- negative - cost to other projects
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