AFM273 Lecture Notes - Lecture 8: Payback Period, Cash Flow, Net Present Value

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amaranthporcupine288

10 Oct 2017

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM273

Professor

Kenneth R Vetzal

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Document Summary

If there is a significant different between the estimated % cost of capital and irr, it will be safe. 6. 2 the internal rate of return internal rate of return investment rule: if irr is greater than the return on other alternatives in the market with equivalent risk and maturity, then you should take the investment opportunity. Irr generally works for projects when negative cash flows precede positive cash flows. In other cases, it may disagree with the npv rule: e. g. you are given million now to work for 3 years, having negative cash flow of ,000 every year (for forgone income). Npv tells us it would reduce our wealth: unconventional cash flow: when we are getting positive cash flows before negative cash flows, the irr rule must be reversed. If there are multiple irrs, use the npv. Use irr to evaluate the estimate of the cost of capital. Payback rule pitfalls in practise: payback rule is not as reliable:

Related Questions

NPV versus IRR Consider the following cash flows on two mutually exclusive projects for the Bahamas Recreation Corporation (BRC). Both projects require an annual return of 14 percent. Year Deepwater Fishing New Submarine Ride 0 â$850,000 â$1,650,000 1 320,000 810,000 2 470,000 750,000 3 410,000 690,000 As a financial analyst for BRC, you are asked the following questions: If your decision rule is to accept the project with the greater IRR, which project should you choose? Because you are fully aware of the IRR ruleâs scale problem, you calculate the incremental IRR for the cash flows. Based on your computation, which project should you choose? To be prudent, you compute the NPV for both projects. Which project should you choose? Is it consistent with the incremental IRR rule?

1. Net Present Value is considered a better method than Internal Rate of Return for all of the following reasons except __________.

a) IRR may misrank mutually exclusive projects of different size

b) IRR can not be used when capital rationing exists

c) IRR may have multiple IRR's if the project is nonnormal

d) IRR assumes cash flows can be reinvested at the project's IRR

2. Which of the following is true for normal projects if the cost of capital is positive?

a. If a project's IRR is positive, then its Profitability Index will greater than 1

b. If a project's NPV is negative, then its Payback period will not exist

c. If a project's NPV is positive, then its Profitability Index will be positive

d. If a project's IRR is positive, then its Discounted Payback period will exist

3. __________ is a method used to compare two repeatable projects with different lives.

Crossover Rate
Equivalent Annual Annuity
Scenario Analysis
Risk Adjusted Discount Rate

4. The __________ is the rate at which two projects have the same NPV is found by calculating the IRR of the difference in the cash flows of two projects.

Risk Adjusted Discount Rate
Marginal Cost of Capital
Crossover Rate
Optimal Capital Budget

5. Which of the following is NOT considered a relevant concern in determining incremental cash flows for a new product?

The use of high quality factory floor space that is currently unused but is available for production of other products.
Revenues from an existing product that would be lost as a result of customers switching to the new product.
Shipping and installation costs associated with preparing the machine to be used to produce the new product.
The cost of a marketing study completed last year related to the new product.

turquoisellama715

Capital budgeting criteria

A firm with a 13% WACC is evaluating two projects for this year's capital budget. After-tax cash flows, including depreciation, are as follows:

0 1 2 3 4 5

Project A -$12,000 $4,000 $4,000 $4,000 $4,000 $4,000
Project B -$36,000 $11,200 $11,200 $11,200 $11,200 $11,200

Calculate NPV for each project. Round your answers to the nearest cent.
Project A $
Project B $

Calculate IRR for each project. Round your answers to two decimal places.
Project A %
Project B %

Calculate MIRR for each project. Round your answers to two decimal places.
Project A %
Project B %

Calculate payback for each project. Round your answers to two decimal places.
Project A years
Project B years

Calculate discounted payback for each project. Round your answers to two decimal places.
Project A years
Project B years

Assuming the projects are independent, which one or ones would you recommend?
-Select-
Only Project B would be accepted because NPV(B) > NPV(A).
Both projects would be accepted since both of their NPV's are positive.
Only Project A would be accepted because IRR(A) > IRR(B).
Both projects would be rejected since both of their NPV's are negative.
Only Project A would be accepted because NPV(A) > NPV(B).
Item 11

If the projects are mutually exclusive, which would you recommend?
-Select-
If the projects are mutually exclusive, the project with the highest positive IRR is chosen. Accept Project A.
If the projects are mutually exclusive, the project with the highest positive MIRR is chosen. Accept Project A.
If the projects are mutually exclusive, the project with the shortest Payback Period is chosen. Accept Project A.
If the projects are mutually exclusive, the project with the highest positive IRR is chosen. Accept Project B.
If the projects are mutually exclusive, the project with the highest positive NPV is chosen. Accept Project B.
Item 12

Notice that the projects have the same cash flow timing pattern. Why is there a conflict between NPV and IRR?
-Select-
The conflict between NPV and IRR is due to the relatively high discount rate.
The conflict between NPV and IRR is due to the fact that the cash flows are in the form of an annuity.
The conflict between NPV and IRR is due to the difference in the timing of the cash flows.
There is no conflict between NPV and IRR.
The conflict between NPV and IRR occurs due to the difference in the size of the projects.
Item 13

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AFM273 Lecture Notes - Lecture 8: Payback Period, Cash Flow, Net Present Value

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