Chapter 7 - Investment decisions Flashcards
Name a fallacy/drawback/difficulty/weakness of the NPV method for choosing investments
The major point is that the cost of capital can be difficult to get 100% correct.
Luckily, we might not have to get it 100% correct. More on that later
how do we mitigate the weakness of the NPV method?
First of all, the NPV method weakness is that the cost of capital can be uncertain.
If we create a so-called NPV profile, which is a graph that shows the relationship between interest rate (cost of capital) and NPV (NPV on Y-axis, rate on X-axis), then we can easily see where the IRR lies in terms of an interest rate/cost of capital. We can use this value as a limit. As long as our cost of capital is better (lower) than the IRR, then the NPV is good, and we should choose the project.
When considering stand-alone projects, what can happen if we do not use the appropriate investment decision method?
if we use the NPV, we are good.
If we use some other method, they may give a result different from NPV. If so, it would mean that we are either accepting a negative NPV project OR rejecting a positive NPV project. Either case is bad for the current value of the firm.
As long as we are considering only stand-alone projects, NPV method is generally the correct one.
What is the difference between the cost of capital and IRR?
The difference between cost of capital and IRR represent the maximum error in the estimate of cost of capital that is allowed without altering the final decision.
when will the IRR decision reule work+
The IRR decision rule is guaranteed to work if all of the negative cash flows precede the positive cash flows.
if this is not the case, the IRR decision rule may give correct or wrong results.
What is actually the IRR decision rule?
Stand alone project.
Take any project where the IRR is higher than the opportunity cost of capital. Turn down all others.
name a pitfall of the IRR decision rule that is different from “negative cashflows must precede positive cash flows”
There can be multiple IRRs. Then which should one take? No easy solution here.
We can also have cases with no IRRs. These are the ones where the NPV is positive for all rates.
elaborate on the payback rule
The payback rule states that you should first find the payback period, which is the time it takes to pay back the original investment. then we check this time against some pre-specified requirement to decide on whether we should accept or reject.
Why does the payback rule suck?
1) It ignores cost of capital and the time value of money
2) Ignores cash flows after the payback period
3) Relies on ad-hoc decision criterion.
Can we use IRR method to compare projects that are mutex?
NO.
Always use NPV.
The reason is that the IRR is completely arbitrary in terms of scale of cash flows, timing etc.
Elaborate on incremental IRR
Incremental IRR refers to the IRR of the incremental cash flow that would result from replacing one project with another project.
We take one project cashflow, and subtracts the other. This is the same as saying “we had the project we subtract, and change to the project we subtract from”.
The IRR of the resulting cash flow is the incremental IRR.
This IRR represent the crossover point where one project becomes better than the other. But it does not necessarily tell us whether the best option is NPV positive.
Can we compare IRRs?
No, since projects have different scales.
key takeaway of this chapter?
Use the NPV rule for decisions, IRR for boundaries.
What is the profitability index?
bang for your buck measure whenever the projects take some resource constraint.
PI = NPV (amounts of resources required)
The profitability index requires 2 conditions in order to be completely accurate:
1) The set of projects taken under the guidance of the method must completely exhaust the resource
2) There is only a single relevant resource
