Chapter 9 Corporate Finance Questions and
Answers Grade A+ 2023
Net Present Value - -The difference between the market value of a project and its cost.
-NPV
How much value is created from undertaking an investment? - --The first step is to estimate the
expected future cash flows.
-The second step is to estimate the required return for projects of this risk level.
-The third step is to find the present value of the cash flows and subtact the initial investment.
-NPV-Decision Rule - -If the NPV is positive, accept the project.
-A positive NPV means that the project is expected to add value to the firm and will therefore
increase the wealth of the owners.
-Since our goal is to increase owner wealth, NPV is a direct measure of how well this project
will meet our goal.
-Decision Criteria Test-NPV - --Does the NPV rule account for the time value of money?
-Does the NPV rule account for the risk of the cash flow?
-Does the NPV rule provide an indication about the increase in value?
-Should we consider the NPV rule for our primary decision rule?
-Internal Rate of Return - -This is the most important alternative to NPV
-It is often used in practice and is intuitively appealing.
lIt is based entirely on the estimated cash flows and is independent of interest rates found
elsewhere
-IRR Definition - -IRR is the return that makes the NPV=0
-IRR Decision Rule - -Accept the project if the IRR is greater than the required return.
-Advantages of IRR - -Knowing a return is intuitively appealing.
-it is a simple way to communicate the value of a project to someone who doesn't know all the
estimation details.
-If the IRR is high enough, you may not need to estimate a required return, which is often a
difficult talk. (be cautious)
-NPV vs. IRR
-Exceptions - -NPV & IRR will generally give us the same decision.
-Nonconvential cash flows-cash flow signs change more than once.
-Mutually exclusive projects
-Initial investments are substantially different(issue of scale)
-Timing of cash flows is substantially different.
, -IRR and Nonconvential Cash flows - -When the cash flows change sign more than once, there is
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 equations.
-IRR an Mutually Exclusive Proects - -1. If you choose one, you can't chose the other.
Example you can choose to attend graduate school at either harvard or stanford but not both.
-Intuitevely, you would us the following dcision rules - -NPV- choose the project with the higher
NPV
IRR- choose the project with the higher IRR
-Conflicts Between NPV & IRR - --NPV directly measure the increase in value to the firm.
-The IRR measures the average return and indicates the sesitivity of the NPV to estimation error
in the required return(cost of capital).
-knowing IRR is very important but dont rely on it.
-Conflicts Between NPV & IRR Continued.. - -Whenever there is a conflict between NPV and
another decision rule, you should ALWAYS use NPV.
IRR is unreliable in the follwoing situations
-nonconventional cash flows
-mutually exclusive projects
-Modifies IRR - --Calculate the net present value of all cash OUTFLOWS using the borrowing
rate.
-Calculate the net future value of all cash INFLOWS using the investing rate.
-Find the rate of return that equates these values.
-B
-Modifies IRR
-Benfits - -Single answer and spcific rates for borrowing and reinvestment.
-Payback Period - -The amount of time required for an investment to generate cash flows
sufficient to recover its initial cost.
-Payback Period Calculations - -Estimate the cash flows.
Subtract the future cash flows from the initial cost untill the initial investment has been
recovered.
-Payback Period Decision Rule - -Accept if the payback period is less than some preset limit.
-Payback Advantages - --Easy to understand
-adjusts for uncertainty of later cash flows.
-Biased toward liquidity
-Pay Disadvantages - --Ignores the time value of money
Answers Grade A+ 2023
Net Present Value - -The difference between the market value of a project and its cost.
-NPV
How much value is created from undertaking an investment? - --The first step is to estimate the
expected future cash flows.
-The second step is to estimate the required return for projects of this risk level.
-The third step is to find the present value of the cash flows and subtact the initial investment.
-NPV-Decision Rule - -If the NPV is positive, accept the project.
-A positive NPV means that the project is expected to add value to the firm and will therefore
increase the wealth of the owners.
-Since our goal is to increase owner wealth, NPV is a direct measure of how well this project
will meet our goal.
-Decision Criteria Test-NPV - --Does the NPV rule account for the time value of money?
-Does the NPV rule account for the risk of the cash flow?
-Does the NPV rule provide an indication about the increase in value?
-Should we consider the NPV rule for our primary decision rule?
-Internal Rate of Return - -This is the most important alternative to NPV
-It is often used in practice and is intuitively appealing.
lIt is based entirely on the estimated cash flows and is independent of interest rates found
elsewhere
-IRR Definition - -IRR is the return that makes the NPV=0
-IRR Decision Rule - -Accept the project if the IRR is greater than the required return.
-Advantages of IRR - -Knowing a return is intuitively appealing.
-it is a simple way to communicate the value of a project to someone who doesn't know all the
estimation details.
-If the IRR is high enough, you may not need to estimate a required return, which is often a
difficult talk. (be cautious)
-NPV vs. IRR
-Exceptions - -NPV & IRR will generally give us the same decision.
-Nonconvential cash flows-cash flow signs change more than once.
-Mutually exclusive projects
-Initial investments are substantially different(issue of scale)
-Timing of cash flows is substantially different.
, -IRR and Nonconvential Cash flows - -When the cash flows change sign more than once, there is
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 equations.
-IRR an Mutually Exclusive Proects - -1. If you choose one, you can't chose the other.
Example you can choose to attend graduate school at either harvard or stanford but not both.
-Intuitevely, you would us the following dcision rules - -NPV- choose the project with the higher
NPV
IRR- choose the project with the higher IRR
-Conflicts Between NPV & IRR - --NPV directly measure the increase in value to the firm.
-The IRR measures the average return and indicates the sesitivity of the NPV to estimation error
in the required return(cost of capital).
-knowing IRR is very important but dont rely on it.
-Conflicts Between NPV & IRR Continued.. - -Whenever there is a conflict between NPV and
another decision rule, you should ALWAYS use NPV.
IRR is unreliable in the follwoing situations
-nonconventional cash flows
-mutually exclusive projects
-Modifies IRR - --Calculate the net present value of all cash OUTFLOWS using the borrowing
rate.
-Calculate the net future value of all cash INFLOWS using the investing rate.
-Find the rate of return that equates these values.
-B
-Modifies IRR
-Benfits - -Single answer and spcific rates for borrowing and reinvestment.
-Payback Period - -The amount of time required for an investment to generate cash flows
sufficient to recover its initial cost.
-Payback Period Calculations - -Estimate the cash flows.
Subtract the future cash flows from the initial cost untill the initial investment has been
recovered.
-Payback Period Decision Rule - -Accept if the payback period is less than some preset limit.
-Payback Advantages - --Easy to understand
-adjusts for uncertainty of later cash flows.
-Biased toward liquidity
-Pay Disadvantages - --Ignores the time value of money
