Chapter 8: Investment Decision Rules Flashcards
How much value is created from undertaking an investment? (3 Steps)
- first step is to estimate the expected future cash flows
- second step is to estimate the required return for projects of this risk level
- third step is to find the present value of the cash flows and subtract the initial investment
NPV Decision Rule
- if the NPV is positive, accept the project
- positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners
- since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal
How long does it take to get the initial cost back in a nominal sense?
- estimate the cash flows
- subtract the future cash flows from the initial cost until the initial investment has been recovered
Payback Decision Rule
accept if the payback period is less than some preset limit
Advantages of Payback
- easy to understand
- adjusts for uncertainty of later cash flows
- biased towards liquidity
Disadvantages of Payback
- ignores the time value of money
- requires an arbitrary cutoff point
- ignores cash flows beyond the cutoff date
- biased against long-term projects, such as research and development, and new projects
How to Compute Discounted Payback Period
- compute the present value of each cash flow and then determine how long it takes to payback on a discounted basis
- compare to a specified required payback period
Discounted Payback Period Decision Rule
accept the project if it pays back on a discounted basis within the specified time
Advantages of Discounted Payback
- includes time value of money
- easy to understand
- does not accept negative estimated NPV investments
- biased towards liquidity
Disadvantages of Discounted Payback
- may reject positive NPV investments
- requires an arbitrary cutoff point
- ignores cash flows beyond the cutoff date
- biased against long-term projects, such as R&D, and new projects
Internal Rate of Return (IRR)
the return that makes the NPV = 0
IRR Decision Rule
accept the project if the IRR is greater than the required return
IRR Investment Rule
- take any investment where the IRR exceeds the cost of capital
- turn down any investment whose IRR is less than the cost of capital
Advantages of IRR
- knowing a return is intuitively appealing
- it is a simple way to communicate the value of a project to someone who doesn’t know all the estimation details
- if the IRR is high enough, you may not need to estimate a required return, which is often a difficult task
- generally leads to the same answers as the NPV method
Disadvantages of IRR
- NPV and IRR will generally give us the same decision
- may result in multiple answers or no answer with non-conventional cash flows
- may lead to incorrect decisions in comparisons of mutually exclusive investments
Mutually exclusive projects
if you choose one, you can’t choose the other
ex. you can choose to attend graduate school next year at either Harvard or Stanford, but not both
Intuitively using NPV and IRR decision rules
- NPV – choose the project with the higher NPV
- IRR – choose the project with the higher IRR
Conflicts Between NPV and IRR
- NPV directly measures the increase in value to the firm
- Whenever there is a conflict between NPV and another decision rule, you should always use NPV
When IRR is unreliable
- non-conventional cash flows
- mutually exclusive projects
Capital rationing
occurs when a firm or division has limited resources
Soft Rationing
the limited resources are temporary, often self-imposed
Hard Rationing
additional capital that cannot be raised due to financial distress or pre-existing contractual agreements
Profitability Index
- measures the benefit per unit cost, based on the time value of money
- useful in situations where we have limited capital (capital rationing)
ex. a profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value
Advantages of Profitability Index
- closely related to NPV, generally leading to identical decisions
- easy to understand and communicate
- may be useful when available investment funds are limited
Disadvantages of Profitability Index
- may lead to incorrect decisions in comparisons of mutually exclusive investments
What is commonly used primary investment criteria?
NPV and IRR
What is commonly used secondary investment criteria?
payback
