2. Investment Decisions and the Enterprise Value Flashcards
I. Introduction II. Investment Valuation Methods III. Specific Problems in Project Evaluation IV. Sensitivity Analysis and Simulation
I. What are the identifying elements of a specific project?
- The object of investment
- Time Horizon, not only as a whole
- Future cash-flows
- Residual value
- Cost of capital
I. Explain the residual Values.
Two types:
- Investment : the amount that is expected to be recovered from the investment made, for example, the value of the second-hand sale of equipment and other fixed assets
- Working Capital: the accumulated value of working capital can be quickly recovered once the project ends
Basically, when the project is very long, we have to calculate both of the residual values: the cf of the years (with the assumption), and the residual value when the project ends.
Note: If a project is not creating value for the company as a hole, but it is creating value for the promoter (shareholder), the company should not take that investment.
II. What are the 4 different Valuation Methods?
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Pay-back period
- Profitability Index
II. Describe the main points about the Net Present Value method.
Decision Rule:
- For only one project: Invest if the NPV>0
- For mutually exclusive projects: choose the one with greater NPV
3 Main attributes:
- uses cash-flows (not net earnings) in project valuation;
- uses all cash-flows related with the project;
- takes into consideration the time value of money (it discounts future cash-flows according to their timing).
II. Describe the main points about the Internal Rate of Return method.
Decision rule: Invest if IRR > Cost of capital (discount rate)
One disadvantage of this method is that it may lead to different conclusions, especially when choosing mutually exclusive projects:
- The possibility of existing 2 or more IRR´s for the same project;
- Project of different dimension (and the problem of the re-investment rate);
- Projects with distinct cash-flow patterns.
Note: IRR is very time sensitive, if we have a high early CF return, that will increase a lot the value of the IRR, which may not be related to the real creation of value
II. Why is there a possibility of existing 2 or more IRR’s for the same project?
It occurs when the project has 2 or more periods with negative cash-flow:
- A project will likely start negative, and then become positive, representing 1 IRR.
- However, if after 5 years, there is one negative cf (because of an investment), that will represent another IRR.
Therefore, the project will have 2 distinct IRR’s.
II. Describe the main points about the Payback Period method.
Definition: Number of periods (usually years) needed so that the sum of cash-flows generated by the project equal its cost.
Decision rule: Invest if the payback period is less or equal to the maximum number of periods the investment can be in operation so that its cost might be recovered.
Problem: the payback period is conceptually wrong and may lead to irrational decisions from the investor perspective.
II. Describe the main points about the Profitability Index method.
Decision rule:
- It there is only one project: Invest if the Profitability Index > 1
- Mutual exclusive projects: Invest in the project that generates higher returns for each € invested.
We use this method when there is not enough money to invest in all the NPV positive projects
III. What are relevant cash-flows.
A relevant cash flow is one that only happens if the project is taken, it only occurs if the company decide to go forward with the project, and that does not happen if the company decides not implement the project.
III. what is a sunk cost. Should it be taken into consideration?
A sunk cost is a cost which already occurred and cannot be recovered.
- In project valuation this costs should be ignored.
III. What is an opportunity cost? Should it be considered in project valuation?
The use of company assets must be considered as a cost of the project, to the extent that it might forego revenues (receipts) resulting from an alternative use of those assets.
Note: The opportunity cost must be equal to the return from the best alternative use of the assets.
III. What are collateral effects? Should it be considered in project valuation?
Collateral effects can also be seen as erosion effects, and occur when an investment project generates a reduction (increase) in the cash-flows of other project.
As a result, the amount of such reduction (increase) must be considered as a negative (positive) cash-flow of the project.
III. What is cost allocation? Should it be considered in project valuation?
Cost allocation happens when a specific investment benefits several different projects (for instance
accounting department).
This cost must be properly allocated to those projects.
However, it should only be considered as a cash-outflow of the project if its implementation increases the cost of the specific project.
III. Name and briefly describe other specific problems in project Evaluation.
-The effects of inflation: Nominal (real) cash-flows must be discounted using nominal (real) discount rates.
- Depreciation costs and tax benefits: Depreciation costs must be considered in the calculation of earnings before taxes, because they generate a tax benefit.
- Projects with different time horizons: It is possible to find some constant cash flows which has a PV equal to the one of non-regular cash flows.
IV. Describe what are sensitivity analysis and analysis of scenarios.
Sensitivity and scenarios analysis are used to determine the sensitivity of NPV to changes in basic assumptions.
- The analysis can be made for each individual variable, for pairs of variables or designing different general scenarios.
