Fin 300 Final Exam notes verified to
pass 2025
Net Present Value(NPV) - correct answer ✔NPV uses cash flows instead of earnings.
NPV uses all relevant cash flows of the project. NPV recognizes the magnitude, risk,
and timing of cash flows, consistent with stock price maximization being the primary
corporate goal.
NPV directly measures the increase in value to the firm.
NPV=PV(Benefits)-PV(Costs) - correct answer ✔DCF valuation,
1. estimate initial costs and future cash flows; how much & when?
2.estimate discount rate appropriate for the risk level of the project
-accept a project is NPV>0
CF - correct answer ✔Cash Flow
NI - correct answer ✔Net Income
How long does it take to get the initial investment back? - correct answer
✔Computation:
1. Estimate the cash flows
2. subtract the future cash flows from the initial cost until the initial investment has been
recovered
-accept if the payback period is less than the cutoff time
Discounted Payback Period - correct answer ✔How long does it take to get the initial
investment back based on the present (or discounted) value of each cash flow?
Discounted Payback period computation - correct answer ✔1.Compute the present
value of each cash flow
2.Determine how long it takes to pay back on a discounted basis
3.Compare to a present limit on the required period
-accept the project if it pays back on a discounted basis within the cutoff time
Advantage of discounted payback - correct answer ✔Includes time value of money
Easy to understand
Does not accept negative estimated NPV investments when all future cash flows are
positive
Biased towards liquidity
Disadvantage of discounted payback - correct answer ✔May reject positive NPV
investments
Requires an arbitrary cutoff point
Ignores cash flows beyond the cutoff point
, Biased against long-term projects, such as R&D and new products
Average Accounting Return (AAR) - correct answer ✔Average Net Income/ Average
Book Value.
May reject positive NPV investments, Requires an arbitrary cutoff point. Ignores cash
flows beyond the cutoff point. Biased against long-term projects, such as R&D and new
products.
-Accept the project if AAR is greater than a present return
Advantage of AAR - correct answer ✔-Easy to calculate
-Needed information is readily available in accounting statements.
Disadvantage of AAR - correct answer ✔-Not a true rate of return; time value of money
is ignored
-Uses an arbitrary benchmark cutoff rate
-Based on accounting net income and book values, not cash flows and market values
Internal Rate of Return (IRR) - correct answer ✔-estimated off cash flows
-independent of interest rates
-return that makes NPV=0
-Accept the project if the IRR is greater than the required return(cost of capital) on the
project
-IRR ignores differences in scale (= size) of mutually exclusive projects.
Advantages of IRR - correct answer ✔-It is a simple way to communicate the value of
a project to someone who doesn't know all the estimation details
-Some may argue an additional advantage of the IRR is if the IRR is high enough, you
may not need to estimate a required return, often a difficult task.
IRR and Mutually Exclusive projects: the scale problem - correct answer
✔Problem=IRR ignores differences in scale (= size) of mutually exclusive projects.
Remedy=Calculate incremental cash flows (large-small) and compare incremental IRR
to the discount rate: Accept the large-budget project if incremental IRR > discount rate
NPV Vs. IRR - correct answer ✔IRR will generally lead to the same decision when
selecting a stand-alone project, unless the project has nonconventional cash flows:
In general, there can be as many IRRs as the times cash flows change signs over time
Specific problem of IRR when selecting mutually exclusive projects: - correct answer
✔-Initial investments are substantially different (issue of scale)
-Timing of cash flows is substantially different
IRR and Nonconventional Cash Flows - correct answer ✔When the cash flows change
sign more than once, there is often more than one IRR
When you solve for IRR you are solving for the root of an equation, and when you cross
the x-axis more than once, there will be more than one return that solves the equation
pass 2025
Net Present Value(NPV) - correct answer ✔NPV uses cash flows instead of earnings.
NPV uses all relevant cash flows of the project. NPV recognizes the magnitude, risk,
and timing of cash flows, consistent with stock price maximization being the primary
corporate goal.
NPV directly measures the increase in value to the firm.
NPV=PV(Benefits)-PV(Costs) - correct answer ✔DCF valuation,
1. estimate initial costs and future cash flows; how much & when?
2.estimate discount rate appropriate for the risk level of the project
-accept a project is NPV>0
CF - correct answer ✔Cash Flow
NI - correct answer ✔Net Income
How long does it take to get the initial investment back? - correct answer
✔Computation:
1. Estimate the cash flows
2. subtract the future cash flows from the initial cost until the initial investment has been
recovered
-accept if the payback period is less than the cutoff time
Discounted Payback Period - correct answer ✔How long does it take to get the initial
investment back based on the present (or discounted) value of each cash flow?
Discounted Payback period computation - correct answer ✔1.Compute the present
value of each cash flow
2.Determine how long it takes to pay back on a discounted basis
3.Compare to a present limit on the required period
-accept the project if it pays back on a discounted basis within the cutoff time
Advantage of discounted payback - correct answer ✔Includes time value of money
Easy to understand
Does not accept negative estimated NPV investments when all future cash flows are
positive
Biased towards liquidity
Disadvantage of discounted payback - correct answer ✔May reject positive NPV
investments
Requires an arbitrary cutoff point
Ignores cash flows beyond the cutoff point
, Biased against long-term projects, such as R&D and new products
Average Accounting Return (AAR) - correct answer ✔Average Net Income/ Average
Book Value.
May reject positive NPV investments, Requires an arbitrary cutoff point. Ignores cash
flows beyond the cutoff point. Biased against long-term projects, such as R&D and new
products.
-Accept the project if AAR is greater than a present return
Advantage of AAR - correct answer ✔-Easy to calculate
-Needed information is readily available in accounting statements.
Disadvantage of AAR - correct answer ✔-Not a true rate of return; time value of money
is ignored
-Uses an arbitrary benchmark cutoff rate
-Based on accounting net income and book values, not cash flows and market values
Internal Rate of Return (IRR) - correct answer ✔-estimated off cash flows
-independent of interest rates
-return that makes NPV=0
-Accept the project if the IRR is greater than the required return(cost of capital) on the
project
-IRR ignores differences in scale (= size) of mutually exclusive projects.
Advantages of IRR - correct answer ✔-It is a simple way to communicate the value of
a project to someone who doesn't know all the estimation details
-Some may argue an additional advantage of the IRR is if the IRR is high enough, you
may not need to estimate a required return, often a difficult task.
IRR and Mutually Exclusive projects: the scale problem - correct answer
✔Problem=IRR ignores differences in scale (= size) of mutually exclusive projects.
Remedy=Calculate incremental cash flows (large-small) and compare incremental IRR
to the discount rate: Accept the large-budget project if incremental IRR > discount rate
NPV Vs. IRR - correct answer ✔IRR will generally lead to the same decision when
selecting a stand-alone project, unless the project has nonconventional cash flows:
In general, there can be as many IRRs as the times cash flows change signs over time
Specific problem of IRR when selecting mutually exclusive projects: - correct answer
✔-Initial investments are substantially different (issue of scale)
-Timing of cash flows is substantially different
IRR and Nonconventional Cash Flows - correct answer ✔When the cash flows change
sign more than once, there is often more than one IRR
When you solve for IRR you are solving for the root of an equation, and when you cross
the x-axis more than once, there will be more than one return that solves the equation
