Investment Decisions Flashcards

Which capital budgeting method calculates the time required to recover the initial investment?

Answer: Payback Period

The payback period measures how long it takes to recover the initial cash outlay from a project's cash inflows.

A project has an initial cost of $100,000 and generates $25,000 per year in cash inflows. What is its payback period?

Answer: 4 years

The payback period is $100,000 ÷ $25,000 = 4 years.

Which capital budgeting technique explicitly incorporates the time value of money?

Answer: Net Present Value

NPV discounts all future cash flows to present value using the required rate of return, directly incorporating the time value of money.

A project's net present value (NPV) is positive. This indicates the project:

Answer: Creates value above the required rate of return

A positive NPV means the project's returns exceed the required rate, creating net value for the firm.

Which of the following is a key limitation of the payback period method?

Answer: It ignores cash flows occurring after the payback period

The payback period ignores all cash flows after the initial investment is recovered, potentially leading to rejection of highly profitable long-term projects.

The profitability index (PI) is calculated as:

Answer: Present value of future cash flows divided by initial investment

The profitability index equals the present value of future cash flows divided by the initial investment, indicating value created per dollar invested.