Discounted Cash Flow Applications Review Questions and Answers
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Course
Discounted Cash Flow
Institution
Discounted Cash Flow
Net Present Value (NPV) The present value of expected cash inflows associated with the investment, less the present value of the investment's expected cash outflows, discounted at the appropriate cost of capital (discount rate).
How to Calculate Net Present Value (NPV) (1) Identify all costs (outf...
Discounted Cash Flow Applications
Review Questions and Answers
Net Present Value (NPV) ✅The present value of expected cash inflows associated
with the investment, less the present value of the investment's expected cash outflows,
discounted at the appropriate cost of capital (discount rate).
How to Calculate Net Present Value (NPV) ✅(1) Identify all costs (outflows) and
benefits (inflows) associated with an investment.
(2) Determine the appropriate discount rate for the investment.
(3) Using the appropriate discount rate, find the PV of each cash flow. Inflows are
positive and increase the NPV. Outflows are negative and decrease the NPV.
(4) Compute the NPV, the sum of the DCF's.
Internal rate of Return (IRR) ✅The rate of return that equates the PV on an
investment's expected benefits (inflows) with the PV of its costs (outflows).
** The IRR may also be defined as the discount rate for which the NPV of an investment
is zero.
Net Present Value (NPV) Decision Rule ✅If an investment has a positive NPV, this
amount goes to the shareholder's. Therefore, if a firm undertakes a project with a
positive NPV, shareholder wealth is increased.
NPV Decision Rules Summarized ✅(1) Accept projects with a positive NPV. Positive
NPV projects increase shareholder wealth.
(2) Reject projects with a negative NPV. Negative NPV projects will decrease
shareholder wealth.
(3) When two projects are mutually exclusive (only one can be accepted), the project
with the higher positive NPV should be accepted.
Internal rate of Return (IRR) Decision Rule ✅(1) Accept projects with an IRR that is
greater than the firm's (investor's) required rate of return.
(2) Reject projects with an IRR that is less than the firm's (investor's) required rate of
return.
** If the IRR is greater than the required rate of return, the NPV is positive, and if the
IRR is less than the required rate of return, the NPV is negative.
Conflicting Decisions between NPV and IRR ✅For mutually exclusive projects, the
NPV and IRR methods can give conflicting project rankings. This can occur when the
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