Chapter 7
Net Present Value and Other Investment
Criteria
Answers to Concept Questions
1.
Assuming conventional cash flows, a payback period less than the project’s life means that
the NPV is positive for a zero discount rate, but nothing more definitive can be said. For
discount rates greater than zero, the payback period will still be less than the project’s life,
but the NPV may be positive, zero, or negative, depending on whether the discount rate is
less than, equal to, or greater than the IRR. The discounted payback includes the effect of the
relevant discount rate. If a project’s discounted payback period is less than the project’s life,
it must be the case that NPV is positive.
2.
Assuming conventional cash flows, if a project has a positive NPV for a certain discount
rate, then it will also have a positive NPV for a zero discount rate; thus, the payback period
must be less than the project life. Since discounted payback is calculated at the same
discount rate as is NPV, if NPV is positive, the discounted payback period must be less than
the project’s life. If NPV is positive, then the present value of future cash inflows is greater
than the initial investment cost; thus, PI must be greater than 1. If NPV is positive for a
certain discount rate
R
, then it will be zero for some larger discount rate
R
*; thus, the IRR
must be greater than the required return.
3.
a.
Payback period is simply the accounting break-even point of a series of cash flows. To
actually compute the payback period, it is assumed that any cash flow occurring during
a given period is realized continuously throughout the period, and not at a single point
in time. The payback is then the point in time for the series of cash flows when the
initial cash outlays are fully recovered. Given some predetermined cutoff for the
payback period, the decision rule is to accept projects that pay back before this cutoff,
and reject projects that take longer to pay back. The worst problem associated with the
payback period is that it ignores the time value of money. In addition, the selection of a
hurdle point for the payback period is an arbitrary exercise that lacks any steadfast rule
or method. The payback period is biased towards short-term projects; it fully ignores
any cash flows that occur after the cutoff point.
b.
The average accounting return is interpreted as an average measure of the accounting
performance of a project over time, computed as some average profit measure
attributable to the project divided by some average balance sheet value for the project.
This text computes AAR as average net income with respect to average (total) book
value. Given some predetermined cutoff for AAR, the decision rule is to accept
projects with an AAR in excess of the target measure, and reject all other projects.
AAR is not a measure of cash flows or market value, but is rather a measure of