Chapter 3 - Investment appraisal - Discounted cash flow techniques

Question 1

What are the 3 reasons for time value of money?

Answer 1

• Consumption preferences
• Inflation
• Risk

Question 2

What is time value of money?

Answer 2

A unit of money obtained today is worth more than a unit of money obtained in the future

Question 3

What is consumption preference?

Answer 3

Would rather have the money today than in a yearWhat

Question 4

What is purchasing power?

Answer 4

e.g., when a car you might want to purchase now may cost more in the future. This would be a loss of purchasing power

Question 5

What is compounding?

Answer 5

Calculates the future (or terminal) value of a given sum invested today for a particular time period at a particular rate of interest.

Question 6

What is the calculation for compounding?

Answer 6

F = P(1 + r) n (power)
F= Future value
P= Initial investment (present value)
r= Interest rate
n= number of time periods

Question 7

What is discounting?

Answer 7

Performs the opposite of compounding. Calculates the present value of an amount received or paid in the future.

Question 8

What is the present value (PV)?

Answer 8

Present value is the cash equivalent now of money receivable/payable at some future date.

Question 9

What is the formula for discounting?

Answer 9

Present value (P) = Future value (F) x (1 + r ) -n (power of)

Question 10

When discounting we use the rate of interest what are the other terms?

Answer 10

• cost of capital
• discount rate
• required return

Question 11

What is Net present value (NPV)?

Answer 11

Discount all the relevant cash flows for a project back to their present values. With cash outflows as negative and cash inflows as positive, ass up all the present values to determine the NPV.

Question 12

what the NPV is negative what will this mean for the project?

Answer 12

not financially viable

Question 13

what the NPV is positive what will this mean for the project?

Answer 13

financially viable

Question 14

what the NPV is zero what will this mean for the project?

Answer 14

breaks even

Question 15

The rate of interest used for discounting reflects what?

Answer 15

the cost of the finance that will be tied up in the investment

Question 16

If company as 2 or more mutually exclusive projects under consideration, which one should it choose?

Answer 16

One with the highest NPV

Question 17

The NPV gives what?

Answer 17

The impact of the project on shareholder wealth

Question 18

The assumption used in discounting regarding when cash flows occur is what?

Answer 18

• all cash flows occur at the start or end of a year

Question 19

The assumption used in discounting regarding when the initial investment occurs is what?

Answer 19

occur at time period 0 (t0)

Question 20

The assumption used in discounting regarding other cash flows occur is what?

Answer 20

other cash flows start one year after that (t1)

Question 21

The assumption used in discounting regarding interest cash flows on funding is what?

Answer 21

do not include interest cash flows on funding (already taken into account within the cost of capital used)

Question 22

What are some advantages of NPV?

Answer 22

Does consider the time value of money
A measure of absolute profitability
Considers cash flow
Considers whole life of the project
Can easily account for risk
Maximises shareholder wealth

Question 23

What are some disadvantages of NPV?

Answer 23

Fairly complex
Not well understood by non-financial managers
It may be difficult to determine the cost of capital
Only considers the long-term, so may lead to short-term demotivation

Question 24

What is annuity?

Answer 24

constant annual cash flow for a number of years

Question 25

What is perpetuity?

Answer 25

annual cash flow that occurs forever.

Question 26

What is the calculation for present value of an annuity?

Answer 26

PV = Annual cash flow x annuity factor (AF)

Question 27

What is the annuity factor?

Answer 27

the name given to the sum of the individual discount factors covering the period of the annuity.

Question 28

What is the calculation of the annuity factor?

Answer 28

1 - (1+r)-n (power) / r

Question 29

What is the calculation of the present value of perpetuity?

Answer 29

PV = Annual cash flow x perpetuity factor

Question 30

The perpetuity factor can be calculated as what?

Answer 30

1 / r

Question 31

For perpetuities whose cash value grows at a constant rate, the perpetuity factor that should be used is what?

Answer 31

1 / (r-g)
g = growth rate

Question 32

What is advanced annuity or perpetuity?

Answer 32

If cash flow starts at t0

Question 33

What is delayed annuity or perpetuity?

Answer 33

If cash flow starts at a time period later than t1

Question 34

What is the IRR?

Answer 34

Internal rate of return represents the discount rate at which the NPV of an investment is zero. As such represents a breakeven cost of capital

Question 35

When should projects be accepted when calculating the IRR?

Answer 35

when greater than the cost of capital

Question 36

How is the IRR calculated?

Answer 36

using linear interpolation.
- calculate two NPVs for a project at 2 different costs of capital
IRR = L + ((Nl / (Nl - Nh) (H-L))
L= lower discount rate
H=higher discount rate
Nl = NPV at the lower discount rate
Nh = NPV at the higher discount rate

Question 37

What are some advantages of IRR?

Answer 37

Considers time value of money
Easily understood
Considers cash flows
Considers whole life of project
Can be calculated without reference to cost of capital

Question 38

What are some disadvantages of IRR?

Answer 38

Doesn’t measure absolute profitability
Linear interpolation is only an estimate
Relatively complicated to calculate

Question 39

If IRR and NPV are in conflict what should be used?

Answer 39

NPV