3.1. Investment Decision Rules Flashcards
Classification of Investment Decision Rules
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- stand alone projects (yes/no)
- choosing between mutually exclusive projects
- program decision
Investment Decision Rule | Choosing between mutually exclusive projects
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- various investment alternatives are available
- only one investment can be conducted
Investment Decision Rule | Program Decision
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- different investments can be carried out at the same time
- budget and resources are given
- simultaneous planning of investment and financing program
What is the NPV Investment Rule?
when making an investment decision, take the alterative with positive NPV. Choosing this alternative is equivalent to receiving its NPV in cash today
What is the IRR Investment Rule? + Remark + 3 Pitfalls
- take any investment opportunity where the IRR exceeds the opportunity cost of capital. turn down any opportunity where IRR is less than the opportunity cost of capital
- Remark: the IRR rule is only guaranteed to work for a stand-alone project is all of the projects negative cash flows precede its positive cash flows
- # 1 Pitfall: Delayed Investments
- # 2 Pitfall: Multiple IRRs
- # 3 Pitfall: Nonexistent IRR
What is the Payback (Investment) Rule?
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- we will take the payback rule as an alternative decision rule for single, stand-alone projects
- the payback investment rule states that you should only accept a project if its cash flows pay back its initial investment within a prespecified period
The payback rule is not as reliable as NPV because it…
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- ignores the projects cost of capital and the time value of money
- ignores cash flows after the payback period
- relies on an ad hoc decision criterion (what is the right number of years to require for the payback period?)
The payback period may give you an impression of…
…. the risk of the project (the longer it takes to get the money back the longer the invested capital is at risk)
NPV Rule and Mutually Exclusive Projects
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- pick the project with the highest NPV
- the NPV expresses the value of the project in terms of cash today, picking the project with the highest NPV leads to the greatest increase in wealth
IRR Rule and Mutually Exclusive Projects
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- IRR rule is difficult to apply in case of mutually exlusive projects
- picking one project over another simply because it has a larger IRR can lead to mistakes
- in particular, when projects differ in their scale of investment, the timing of their cash flows or their riskiness then their IRRs cannot be meaningful compared
Common Mistake: IRR and Project Financing
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- IRR not itself a measure of value: easily manipulated by restructuring the projects cash flows
- IRR can easily be increased by financing a portion of the initial investment
- higher IRR does NOT indicate that financing is attractive!!!
Project Selestion with Resource Constraints
If there is a fixed supply of the resource so that you cannot undertake all possible opportunities, the firm…
….must choose the best set (!) of investments it can make given the resources it has available
What is the Profitability Index?
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- often used by practitioners to identify the optimal combination of projects to undertake in such situations
- measures the “bang for the buck”
- projects are ranked based on this index
- = Value Created / Resource Consumed
- OR - NPV / Resource Consumed
The Profitability Index will only be reliable if the following two conditions hold
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- the set of projects taken following the profitability index ranking completely exhausts the available resource
- there is only a single relevant resource constraint
