AFM273 Chapter Notes - Chapter 6: Payback Period, Net Present Value

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coffeezebra978

17 Feb 2015

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM273

Professor

Garvin Blair

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Document Summary

Chapter 6: the difference b/w the cost of capital and irr is max. amount of estimation error in the cost of capital estimate that can exist without altering the original decision. Npv rule: accept project when npv is positive. Internal rate of return (irr) investment rule: the rate of irr is when npv = 0, take investment where irr > cost of capital. Turn down investment where irr < cost of capital. Irr rule has shortcomings for making investment decisions. Irr measures the average return of the investment and the sensitivity of the npv to any estimation error in the cost of capital. Payback rule: payback period is the amount of time it takes to recover or pay back initial investment. If payback period is less than pre-specified length of time, accept the project. Mutually exclusive projects: when you must choose only one project among several possible projects, choice is mutually exclusive, npv rule select project with highest npv.

Related Questions

Which of the following five statements are correct?

The effective annual rate (EAR) for a loan with a stated APR of 8% compounded monthly is about 8.3%.

Fundamentally, interest rates are determined by the Federal Reserve (central bank).

The rate of growth of your purchasing power is determined by the nominal interest rate.

Real interest rates indicate the rate at which your money will grow if invested for a certain period.

The investor's opportunity cost of capital is the best available expected return offered in the market on an investment of comparable risk and term of the cash flows being discounted.

Which of the following five statements are correct?

When the risks of two projects are different, only the NPV rule will give a reliable answer.

When the risks of two projects are different, only the IRR rule will give a reliable answer.

The IRR investment rule states you should turn down any investment opportunity where the IRR is less than the opportunity cost of capital.

The profitability index can can be easily adapted for determining the correct investment decisions when multiple resource constraints exist.

You are trying to decide between three mutually exclusive investment opportunities. The most appropriate tool for identifying the correct decision is the profitability index.

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

1. Understand how to use EXCEL Spreadsheet
(a) Develop proforma Income Statement Using ExcelSpreadsheet
(b) Compute Net Project Cashflows,NPV, and IRR
(c) Developproblem-solving and critical thinking skills
	and make long-term investment decisions

1) LifePeriod of the Equipment = 4 years			8) Sales for first year (1)			$200,000
2) Newequipment cost		$(200,000)	9) Sales increase per year			5%
3)Equipment ship & install cost		$(35,000)	10) Operating cost (60% of Sales)			$(120,000)
4) Relatedstart up cost		$(5,000)	(as a percent of sales in Year 1)			-60%
5)Inventory increase		$25,000	11) Depreciation (Straight Line)/YR			$(60,000)
6) AccountsPayable increase		$5,000	12) Marginal Corporate Tax Rate (T)			21%
7) Equip.salvage value before tax		$15,000	13) Cost of Capital (Discount Rate)			10%



ESTIMATING Initial Outlay (Cash Flow, CFo, T= 0)

		CF0	CF1	CF2	CF3	CF4
Year		0	1	2	3	4
Investments:
1)Equipment cost
2) Shippingand Install cost
3) Start upexpenses
Total Basis Cost (1+2+3)
4) Net Working Capital
Total Initial Outlay

Operations:
Revenue
OperatingCost
Depreciation
EBIT
Taxes
Net Income

Addback Depreciation

Total Operating Cash Flow			XXXXX	XXXXX	XXXXX	XXXXX

Terminal:
1) Changein net WC			$-	$-	$-	$20,000
2) Salvagevalue (after tax)		Salvage Value Before Tax (1-T)				XXXXX
Total						XXXXX

Project Net Cash Flows		$-	$-	$-	$-	$

NPV =		IRR =			Payback=

Q#1	Would you accept the project based on NPV, IRR?
	Would you accept the project based on Payback rule if projectcut-off
	is 3years?
Q#2 Impact of 2017 Tax Cut Acton Net Income, Cash Flows and
	Capital Budgeting (Investment ) Decisions
(a)	Estimate NPV, IRR and Payback Period of the project if equipment isfully
	depreciated in first year and tax rate equalsto 21%. Would you
	accept or reject the project?
(b)	As a CFO of the firm, which of the above two scenario(a) or (b)
	would you choose? Why?
Q#3 How would you explain to your CEOwhat NPV means?
Q#4 What are advantages anddisadvantages of using only Payback method?
Q#5 What are advantages and disadvantages of usingNPV versus IRR?
Q#6 Explain the difference between independent projectsand mutually exclusive projects.
	When you are confronted with Mutually Exclusive Projects and havecoflicts
	with NPV and IRR results, which criterion would you use (NPV orIRR) and why? *****SHOW WORK PLEASE !!!!

mauvespider741

AFM273 Chapter Notes - Chapter 6: Payback Period, Net Present Value

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