Term
| Qualities of a good criterion |
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Definition
all relevant cash flows are included in the analysis
the time value of money is included in the analysis
the risk of the cash flows is included in the analysis
decisions based on the criteria maximize shareholder value |
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Term
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Definition
fundamentally the same as discounted cash flow analysis
estimates how much value is created from undertaking an investment
accept if NPV > 0 |
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Term
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Definition
1. estimate expected cash flows
2. estimate the required rate of return based on the project's risk
3. find PV of cash flows and subtract the initial investment |
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Term
| the market value of a firm is based on the |
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Definition
| present value of the CF it is expected to generate |
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Term
| additional investments are "good" if |
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Definition
| the PV of the incremental expected cash flows exceeds their cost. |
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Term
| "good" projects are those which |
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Definition
| increase firm value (have a positive NPV) |
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Term
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Definition
similar to NPV, don't need r upfront
solves for the RETURN that makes NPV zero.
Decision rule: accept if IRR > required rate of return
(if required is 8% and you're getting 10%, take the project)
( it depends on the risk of the project) |
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Term
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Definition
most important second to NPV
simple way of communicating the value of a project to someone who doesn't know all the estimation details
based on estimated cash flows and independent of interest rates found elsewhere
if IRR is high enough, you may not need to estimate a required return (knowing normal is 10% and can calculate 28%, unnecessary to be entirely accurate) |
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Term
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Definition
can be two values for the discount rate that yield NPV = 0
when choosing between 2 projects that are MUTUALLY EXCLUSIVE, IRR may result in choosing the project with a lower NPV
--IRR ignores the scale of the investment |
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Term
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Definition
Initial cash flow is negative and the rest are positive.
If it's conventional, IRR is good.
If there are multiple solutions, don't use IRR if they're not conventional. |
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Term
| IRR maximizes shareholder value under two assumptions: |
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Definition
CF must be conventional
can't have mutually exclusive projects |
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Term
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Definition
NPV directly measures the increase in value to the firm--max shareholder value
Always use NPV if there is a conflict
IRR is unreliable in: non-conventional cash flows and mutually exclusive projects |
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Term
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Definition
an index instead of a dollar amount (has no units, is an index)
-easy to understand and communicate
-measures the benefit per unit cost, based on the time value of money
-a profitability index of 1.1 implies that for every $1 of investment, we create an additional $.10 in value
-can be useful in situations with limited capital |
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Term
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Definition
PI ignores the scale of the project. if projects are mutually exclusive, it may not choose the one with the highest NPV
doesn't count the relative scale of index |
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Term
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Definition
how long it takes to recover the initial investment
for fractional year, divide the remaining cash flow needed to cover investment by the total cash flow for that year
Decision Rule: accept if--payback period < pre-specified (or hurdle) period |
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Term
| benefits of payback period |
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Definition
simple
adjusts for uncertainty of later cash flows
biased towards liquidity |
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Term
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Definition
ignores time value of money
ignores distant cash flows
ignores cash flow risk (ignores distant cash flows altogether, one sense in which risk is being considered)
biased toward short term investments and can lead to under-investment
hurdle period must be determined arbitrarily |
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Term
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Definition
how long it takes the discounted cash flows to payback the initial investment
--accounting for the future time value of money
accept if discounted payback < pre-specified (hurdle) period |
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Term
| benefits of discounted payback |
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Definition
includes time value of money
simple
doesn't accept negative estimated NPV investments when all future cash flows are positive
biased towards liquidity |
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Term
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Definition
may reject positie NPV investments (under investment)
ignores distant cash flows
biased towards short rem investments and can lead to under investment
cutoff must be determined arbitrarily |
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