NPV, IRR, payback, profitability index, project cash flows and risk analysis in capital budgeting.
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- What is Net Present Value (NPV)?
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The present value of a project's future cash flows minus its initial investment, discounted at the project's cost of capital.- What is the NPV decision rule for independent projects?
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Accept the project if NPV is positive; reject if NPV is negative or zero.- Name one advantage of using NPV for capital budgeting decisions.
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NPV directly measures the change in firm value; a positive NPV means the project adds shareholder wealth.- What is a major limitation of the NPV method?
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It requires estimating the appropriate discount rate, which can be difficult and subjective, especially for risky projects.- What is the Internal Rate of Return (IRR)?
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The discount rate that makes the NPV of a project equal to zero; the yield or return earned on the project.- What is the IRR decision rule for independent projects?
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Accept the project if its IRR exceeds the cost of capital; reject if IRR is less than the cost of capital.- Name one advantage of the IRR method.
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IRR is expressed as a percentage return, which is intuitive and easy to communicate to non-financial managers.- What problem can arise with IRR when projects have cash flows spread over many periods?
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The IRR assumes reinvestment of intermediate cash flows at the IRR rate, which may be unrealistic.- What is the simple payback period?
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The number of years it takes for a project's cumulative cash inflows to recover its initial investment, ignoring the time value of money.- What is the discounted payback period?
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The number of years it takes for a project's cumulative discounted cash flows to recover its initial investment.- What is a major weakness of the payback period method?
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It ignores cash flows that occur after the payback period, so it may reject valuable long-lived projects.- What is the Profitability Index?
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The present value of future cash flows divided by the initial investment; also called the benefit-cost ratio.- What is the profitability index decision rule for independent projects?
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Accept the project if the profitability index exceeds 1.0; reject if it is less than 1.0.- When is the profitability index most useful?
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In capital rationing situations where funds are limited and you must rank projects by their value per dollar invested.- What are the three main components of project cash flows?
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Operating cash flows, capital expenditures, and changes in working capital.
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