3. Investment decisions Flashcards
What is capital budgeting?
It is the process by which we determine if a firm’s long term investments are worth pursuing.
What are the rules for capital investment?
- Net present value rule: accept investments with positive net present values
- Rate of return rule: accept investments that offer rates of return in excess of their opportunity cost of capital
What is the rate of return of an investment?
It is the profit as a proportion of the initial outlay
What is the net present value of an investment?
It represents the total present value of a time series of cash flows.
Future cashflows are discounted back to their present value and are summed up
What is the opportunity cost of capital for an investment?
It is the expected rate of return demanded by investors
How is a cashflow computed?
Inflow - Outflow
What is the internal rate of return?
IRR
It is the annualized effective compounded return rate which can be earned on the invested capital.
If IRR > rate of return of other investments = good investment
If IRR > k ,project will bting value to the company
It is the rate for which the net present value equals zero
What is the profitability index?
It is the ratio of payoff to investment of a proposed project.
If Pi = 1 (breakeven)
What is the payback period?
The payback period is the time required to recover from the initial investment through the project’s cash inflows.
What is the weighted average cost of capital
WACC
It is a weighted average of the cost of equity and the cost of debt
It is the minimum return a company must generate on an existing asset to satisfy its creditors/owners or they will invest elsewhere
