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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 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 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 short-term projects; it fully ignores any cash flows that occur after the cutoff point. c. Despite its shortcomings, payback is often used because the analysis is straightforward and simple. 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 short-term projects where cash management is most important. 4. a. The average accounting return is interpreted as an average measure of the accounting perfor- mance 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 addition, the selection of a cutoff is arbitrary, and the time value of money is ignored. For a financial
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