Chapter 2 Flashcards
What Is Net Present Value (NPV)?
NPV, or net present value, is how much an investment is worth throughout its lifetime, discounted to today’s value.
NPV accounts for the time value of money and can be used to compare the rates of return of different projects.
NPV, or net present value, is how much an investment is worth throughout its lifetime, discounted to today’s value.
What Is a Hurdle Rate?
A hurdle rate is the minimum rate of return a project or investment must achieve before the manager or investor approves a predetermined condition. It allows companies to make important decisions on whether or not to pursue a specific project. The hurdle rate describes the appropriate compensation for the level of risk present—riskier projects generally have higher hurdle rates than those with less risk.
How we can justify if an investment is worth undergoing?
Net present value rule. Accept investments that have positive net present values.
∙ Rate of return rule. Accept investments that offer rates of return in excess of their opportunity costs of capital
What Is Discounted Cash Flow (DCF)?
Discounted cash flow (DCF) refers to a valuation method that estimates the value of an investment using its expected future cash flows.
DCF analysis attempts to determine the value of an investment today, based on projections of how much money that investment will generate in the future.
It can help those considering whether to acquire a company or buy securities make their own decisions.
To conduct a DCF analysis, an investor must make estimates about multiple future cash flows
When a company analyzes whether it should invest in a certain project or purchase new equipment, it usually uses its weighted average cost of capital (WACC) as the discount rate to evaluate the DCF.
The WACC incorporates the average rate of return that shareholders in the firm are expecting for the given year.
For example, say that your company wants to launch a project. The company’s WACC is 5%. That means that you will use 5% as your discount rate.
What is the difference between a perpetuity and an annuity?
Annuities are investments that make payments for a set duration of time. Perpetuities are investments that make payments indefinitely.
-Examples of perpetuity: are consols (type of government bonds), bonds without a maturity date.
-Examples of annuities: are car loans, mortgages, and life insurance.
An annuity is equivalent to the difference between an immediate
and a delayed perpetuity
How Interest is paid and quoted?
Effective Annual Interest Rate (EAR)
- Interest rate annualized using compound interest
Annual Percentage Rate (APR)
- Interest rate annualized using simple interest
