Chapter 8: Capital Budgeting / NPV / Other Investment Criteria

Question 1

What is the Net Present Value of an investment?

Answer 1

Measures the difference between its value and cost. Therefore the amt that the project will add to shareholder wealth. A company maximises shareholder wealth by accepting all projects that have a positive NPV.

Question 2

What is the formula for NPV?

Answer 2

NPV = PV - required investment

or

NPV = C(0) + C(1)/(1+r)^1 + C(2)/(1+r)^2...C(N)/(1+r)^n
C(N)= Cash flow at any time
n= time period of the investment
r= opportunity cost of capital

Question 3

How is the internal rate of return in a project calculated?

Answer 3

Instead of asking whether a project has a positive NPV, many businesses prefer to ask whether it offers a higher return than shareholders could expect to get by investing in the capital market. Return is usually defined as the discount rate that would result in a zero NPV. This is know as the internal rate of return (IRR). The project is attractive if the IRR exceeds the opportunity cost of capital.

Question 4

What is the opportunity cost of capital?

Answer 4

Opportunity cost analysis also plays a crucial role in determining a business’s capital structure. While both debt and equity require expense to compensate lenders and shareholders for the risk of investment, each also carries an opportunity cost. Funds used to make payments on loans, for example, are not being invested in stocks or bonds, which offer the potential for investment income. The company must decide if the expansion made by the leveraging power of debt will generate greater profits than it could make through investments.

Question 5

What must one be careful with when using the Internal Rate of Return (IRR) rule?

Answer 5

(1) you need to choose between mutually excl. projects
(2) there is more than one change in the sign of the cash flows
(3) the early cash flows are positive

Question 6

How can the profitability index be used to choose between projects when funds are limited?

Answer 6

If there is a shortage of capital, companies need to choose projects that offer the highest NPV per dollar of investment. This measure is knows as the profitability index.

Question 7

What is the profitability index?

Answer 7

Ratio of NPV to initial investment. NPV / initial investment

Because profitability index calculations cannot be negative, they consequently must be converted to positive figures before they are deemed useful. Calculations greater than 1.0 indicate the future anticipated discounted cash inflows of the project are greater than the anticipated discounted cash outflows. Calculations less than 1.0 indicate the deficit of the outflows is greater than the discounted inflows, and the project should not be accepted. Calculations that equal 1.0 bring about situations of indifference where any gains or losses from a project are minimal.

Question 8

What is Internal Rate of Return (IRR)?

Answer 8

The discount rate at which project NPV equals zero.

Question 9

What is the investment rule associated with NPV?

Answer 9

Accept the project if NPV is positive. For mutually excl projects, choose the one with the highest (positive) NPV. Given zero capital rationing, the NPV rule attains the aforementioned optimal investment criteria.

Question 10

What is the investment rule associated with IRR?

Answer 10

Accept project if IRR is greater than opportunity cost of capital. With / without capital rationing, the profitability index is optimal.

Requirements:

• independent projects - cashflows unrelated btwn projects
• not mutually excl. acceptance of one project does not preclude other
• negatively sloped NPV profile - this demonstrates that you receive ‘x’ now (e.g. $100) but have to pay ‘x+’ later (e.g. $150) (an NPV profile is a graph showing the relationship between a project’s NPV and the firm’s cost of capital. The point where a project’s net present value profile crosses the horizontal axis indicates a project’s internal rate of return).

Question 11

What is the investment rule with the profitability index?

Answer 11

Accept project if profitability index is greater than 0. In case of capital rationing, accept projects with highest profitability index. Possibly a sub-optimal rule; even without capital rationing, does not necessarily maximise shareholder value.

Question 12

What is the investment rule associated with payback period?

Answer 12

Accept project if payback period is less than some specified number of years. Possibly a sub-optimal rule; even without capital rationing, does not necessarily maximise shareholder value.

Question 13

What are some of the challenges with NPV?

Answer 13

‘Problems’
– Difficult to forecast revenues
– Difficult to model (understand) the OCC
– May imply sub optimal investment in context of capital rationing

Question 14

What are the two criteria that must be met for an investment decision technique to accomplish the goal of maximising stakeholder wealth?

Answer 14

1) All relevant cash flows from the investment project should be considered.
• Specifically, managers should consider each project independently from all others (i.e. the notion of the notion of incremental cash flows)
2) The cash flows should be discounted at the opportunity cost of capital (i.e. the return foregone by investing in the project rather than best alternative securities of same risk).

Question 15

What is capital rationing?

Answer 15

Capital rationing is the act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on specific portions of a budget. Companies may want to implement capital rationing in situations where past returns of an investment were lower than expected.

Soft rationing: limits imposed by management.
Hard rationing: limits imposed by unavailability of funds in the capital market.

Question 16

What is the investment rule associated with capital rationing?

Answer 16

Select projects according to the magnitude of their Profitability Indexes.
PI(i)=NPV(i)/C(0)(i)

Question 17

Why doesn’t the payback rule always make shareholders better off?

Answer 17

The NPV and IRR rules both properly reflect the time value of money. But companies sometimes use rules of thumb to judge projects. One is the payback rule, which states that a project is acceptable if you get your money back within a specified period. The payback rule takes no account of any cash flows that arrive after the payback period and fails to discount cash flows within the payback period.