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Fin 300 Final Exam notes.
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Fin 300 Final Exam notesNet Present Value(NPV)
NPV uses cash flows instead of earnings. NPV uses all relevant cash flows of the project. NPV recognizes the magnitude, risk, and timing of cash flows, consistent with stock price maximization being the primary corporate goal.
NPV directly measures the increase in value to the firm.
NPV=PV(Benefits)-PV(Costs)
DCF valuation,
1. estimate initial costs and future cash flows; how much & when?
2.estimate discount rate appropriate for the risk level of the project
-accept a project is NPV>0
CF
Cash Flow
NI
Net Income
How long does it take to get the initial investment back?
Computation:
1. Estimate the cash flows
2. subtract the future cash flows from the initial cost until the initial investment has been recovered
-accept if the payback period is less than the cutoff time
Discounted Payback Period
How long does it take to get the initial investment back based on the present (or discounted) value of each cash flow?
Discounted Payback period computation
1.Compute the present value of each cash flow
2.Determine how long it takes to pay back on a discounted basis
3.Compare to a present limit on the required period
-accept the project if it pays back on a discounted basis within the cutoff time
Advantage of discounted payback
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
Disadvantage of discounted payback
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
Average Accounting Return (AAR)
Average Net Income/ Average Book Value.
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.
-Accept the project if AAR is greater than a present return
Advantage of AAR
-Easy to calculate
-Needed information is readily available in accounting statements.
Disadvantage 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
Internal Rate of Return (IRR)
-estimated off cash flows
-independent of interest rates
-return that makes NPV=0
-Accept the project if the IRR is greater than the required return(cost of capital) on the project
-IRR ignores differences in scale (= size) of mutually exclusive projects.
Advantages of IRR
-It is a simple way to communicate the value of a project to someone who doesn't know all the estimation details
-Some may argue an additional advantage of the IRR is if the IRR is high enough, you may not need to estimate a required return, often a difficult task.
IRR and Mutually Exclusive projects: the scale problem
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