FIN 357 Study Guide - Midterm Guide: Net Present Value, Payback Period, Cash Flow

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4 Jan 2017
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Finance Exam 3 Notes
Net Present Value and Other Investment Rules
Why use NPV?
- Focus on capital budgeting decision making process for accepting or rejecting projects
- NPV accept a project if NPV > 0, reject if NPV < 0 NPV rule
- Accepting positive NPV projects benefits the stockholders
- The value of the firm rises by the NPV of the project
- Value additivity = sum of the values o the different projects, divisions, or other entities within
the firm
o Implies that contribution of any project to a firm’s value is simply the NPV of the project
- Opportunity cost = discount rate on a risky project that one can expect to earn on a financial
asset of comparable risk.
- NPV has three attributes:
o NPV uses cash flows cash flows are useful for other purposes such as dividend
payments, capital budgeting projects, or corporate interest payments on the other
hand, earnings are artificial do not represent cash so should not be used for capital
budgeting
o NPV uses all the cash flows of the project other approaches ignore cash flows beyond
a particular date BAD
o NPV discounts cash flows properly other approaches ignore time value of money when
handling cash flows
7.2 The Payback Period Method
Payback period rule particular cutoff date is selected all projects that have payback periods before
the cutoff date are accepted and all those that pay off after the cutoff date are rejected
Problems with the payback method
- Timing of Cash Flows within the payback period: does not consider timing of cash flows within
payback period NPV discounts the cash flows properly
- Payments after the Payback period: method ignores all cash flows occurring after the payback
period short-term orientation means that some valuable long-term projects are likely to be
rejected NPV uses all the cash flows of the project
- Arbitrary standard for payback period: no real way to guide choosing the payback cutoff date
so the choice is somewhat arbitrary
Managerial Perspective
- Most often used by large, sophisticated companies when making relatively small decisions
- Easy to assess whether investment in the project was right or wrong because of the short-term
nature
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