2. Investment Appraisal

Question 1

What are some strengths of NPV?

Answer 1

• NPV uses cash flow rather than earnings.
• NPV considers all the cash flows of the project.
• NPV fully incorporates the time value of money.

Question 2

What is the payback period method and criterion?

Answer 2

The payback period method is an investment appraisal technique which uses the payback period. The payback period is the time until cash flows recover the initial investment of the project. One should only accept projects that have a payback period less than or equal to a cut-off date (payback period chosen to be acceptable).

Question 3

What are some weaknesses of the payback period method?

Answer 3

• It does not consider the timing of cash flows within the payback period.
• Payments after the payback period not accounted for.
• The standard for payback period is somewhat arbitrary.

Question 4

What are some advantages of the payback period method?

Answer 4

• Quick to evaluate a manager’s decision making ability.
• Very easy to understand and use.
• Very useful for firms with small amount of working capital.
• Gives an insight into how long it will take for a project to start generating positive value (discounted PP does especially).

Question 5

What are problems with AAR?

Answer 5

• It does not use cash flows.
• It does not take into account the time value of money.
• The targeted (‘right’) rate of return is arbitrary.

Question 6

Why is the interal rate of return referred to as ‘internal’?

Answer 6

It does not depend on an external factor such as the interest rate prevailing in the capital market (like the discount rate in NPV). The number is internal or intrinsic and does not depend on anything except the cash flows of the project.

Question 7

What is the internal rate of return (IRR) of a project?

Answer 7

The discount rate for which NPV = 0.
It is usually determined through trial and error calculations.

Question 8

What is the IRR rule for investment type projects (cash outflow followed by inflows)?

Answer 8

If r < IRR, the project should be accepted.
If r > IRR, the project should be rejected.

This coincides with the NPV rule because investment type projects with r < IRR have a NPV > 0.

Therefore, the higher the IRR, the better the investment project.

Question 9

What is the IRR rule for financing projects (cash inflows followed by cash ouflow)?

Answer 9

If r < IRR, the project should be rejected.
If r > IRR, the project should be accepted.

Therefore, the lower the IRR, the better the financing project.

Question 10

What are some problems with the IRR method?

Answer 10

• It does not work for projects where there are 2 or more changes of sign of cash flows (as there will be more than one IRR).
• One mutually exclusive project can seem more appealing than the other even if it has a lower NPV (scale problem).

Question 11

How can the scale problem of IRR be overcome?

Answer 11

By calculating the incremental IRR and accepting the project if it is greater than the discount rate used in NPV calculations for the projects.

Question 12

How can we handle a mutually exclusive investment scenario?

Answer 12

• Compare the NPVs of the two choices. Calculate the incremental NPV.
• Compare the incremental IRR to the NPV discount rate used.

Question 13

What is the profitability index (PI) criterion?

Answer 13

Accept a project if PI > 1, reject a project if PI < 1.

Question 14

What is the discount rate used in investment appraisal calculations for unlevered (all-equity) companies?

Answer 14

The expected return (a.k.a. Cost of equity capital)

Question 15

What is the discount rate used in investment appraisal calculations for levered companies (financed with both equity and debt?

Answer 15

The weighted average cost of capital (WACC)