Ch. 5A - Investment Decision Rules Flashcards
What are the different investment decision rules?
- ARRs
- Payback Period
- NPV
- IRR
- PI
What is the most common ARR?
ROC (Return on Capital) because ROC links the idea of investing capital into the project
ARR Decision Rule
Compare the ROC with the ROCs of other known projects. See if it compares favourably or not (bigger ROC is better).
Payback Period
How long it will take (in years) to get back your initial investment
What is are the issues with using the payback period decision rule?
- No TVM
- Ignores any income after the payback period
- Relative comparison only, no absolute decision
NPV Decision Rule
Positive NPV -> Accept Project
Negative NPV -> Reject Project
What is the main issue with the NPV decision rule?
NPV does not consider the amount of capital tied up (we need to use Profitability Index to consider this)
Internal Rate of Return (IRR)
The discount rate which makes the PV of the future cash flows equal to the observed price (IRR is the discount rate that makes NPV = 0)
Conventional Cash Flows
First cash flow (CF0) is negative. All other cash flows are positive or zero. Guaranteed to have only 1 IRR
Unconventional Cash Flows
Cash flows are positive and negative. Possible to have multiple IRRs
How many IRRs can there be?
There may be as many IRRs as the number of times the cash flows change sign
What are some potential reasons cash flows may be unconventional?
- Occasional large maintenance costs
- Can arise when analyzing incremental projects
Profitability Index (PI) Decision Rule
PI > 1 is good
PI < 1 is bad
What is the difference between the NPV and PI decision rules?
NPV ranks on change in wealth but ignores the capital needed to be tied up in the project. PI ranks projects based on their profitability
What are the 3 methods we can use to compare projects with unequal lives?
- Constant chain of replacement (CCR)
- Lowest common multiple of years
- Equivalent annual value (EAV)
