Chapter 8: Net Present Value And Other Investment Criteria
Answers to Concepts Review and Critical Thinking Questions
1.
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.
2.
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. 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 breakeven 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 payback before this cutoff, and reject projects
that take longer to payback.
b.
The worst problem associated with payback period is that it ignores the time value of
money. In addition, the selection of a hurdle point for payback period is an arbitrary
exercise that lacks any steadfast rule or method. The payback period is biased towards
shortterm projects; it fully ignores any cash flows that occur after the cutoff point.
c.
Despite its shortcomings, payback is often used because (1) the analysis is
straightforward and simple and (2) accounting numbers and estimates are readily
available. Materiality considerations often warrant a payback analysis as sufficient;
maintenance projects are another example where the detailed analysis of other methods
is often not needed. Since payback is biased towards liquidity, it may be a useful and
appropriate analysis method for shortterm projects where cash management is most
important.
4.
a.
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 due 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.
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b
.
AAR is not a measure of cash flows and market value, but a measure of financial
statement accounts that often bear little semblance to the relevant value of a project. In
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 Fall '08
 DICLE
 Net Present Value, PAYBACK PERIOD, IRRs

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