chapter 8 - Net Present Value Flashcards
capital budgeting decision def
- which projects should the firm invest in?
- known as the capital budgeting decision or the investment decision
-many criteria available to evaluate investments
NPV def
Present value of cash flows minus initial investment
opportunity cost of capital def
expected rate of return given up by investing in a project
NPV formula
NPV = PV - required investment
NPV = C0 + C1/(1+r) + C2/(1+r)^2+….+ Ct/(1+r)^t
works for projects of any duration
critical problems in NPV exercices
- determine the amount and timing of the cahs flows
- the appropriate discount rate
NPV rule
- managers increase shareholders’ wealth by accepting all projects that are worth more than they cost => accept all projects with positive NPV
for single project:
- do it iff its NPV is positive
for many independent projects:
- do it for all positive NPV projects
for mutually exclusive projects:
- choose the one with the highest NPV
Other investment criteria than NPV
- most firms use the NPV criterion (it will maximize the value of a firm’s shares)
- other criteria are used because: some give wrong answers, some require work to get
2most common : payback, discounted payback, Internal Rate of Return, profitability index
payback period def
time until cash flows recover the initial investment of the project
payback rule
accept a project if its payback period is less than the specified cutoff period
payback method drawbacks
- does not consider any cash flows that arrive after the payback period
- gives equal weight to all cash flows arriving before the cutoff period even though distant cash flows are more valuable
- difficult to find the optimal cutoff period
discount payback period def
discounted payback is the time period it takes for the discounted cash flows generated by the project to cover the initial investment in the project
advantages and drawbacks of discounted payback method
advantage:
- helps to find the cutoff
drawbacks:
- ignores all cashflows occurring after the arbitrary cutoff
- easily misrank competing projects
internal rate of return (IRR) def
IRR is the discount rate at which the NPV of the project equals 0
IRR rule
accept a project if it offers a rate of return higher than the opportunity cost of capital
how to find the IRR
solve for r : NPV = [C1/(1+r)] - C0
with NPV = 0
or use a graph method: the point where NPV line crosses the x-axis is the IRR
project rate of return and NPV
- the rate of return is the discount rate that will give a project an NPV = 0.
- if opportunity cost of capital < project rate of return => NPV is positive
- if opportunity cost of capital > project rate of return => NPV is negative
finding the rate of return on long-lived projects
rate of return = profit/investment = (C1 - C0)/C0
drawbacks of IRR
- does not consider if the money is lended or borrowed: pick the project where you earn more than the opportunity cost of capital
- mutltiple rate of returns: if projects have more than one discount rate it doesn’t work
- mutually exclusive projects it doesnt consider the size only the rate: choose the one with the highest NPV
three challenges of choosing between mutually exclusive projects
- investment timing decision
- choice between long-lived vs short-lived equipment
- replacement problem
investment timing decision def
sometimes you can defer an investment and select a time that is more idea at which to make the investment decision
- the decision rule is to choose the investment date that results in the highest NPV today
long- lived vs short-lived equipment
for comparing assets with different lives we need to compare their Equivalent Annual Costs
The equivalent annual cost (EAC) is the cost per period with the same OV as the cost of the machine
- if mutually exclusive projects have unequal lives then you should calculate the equivalent annual costs of the projects
replacement problem
when should existing machinery be replaced ?
compare the cost of operating the old asset with the equivalent annual cost of the new
soft rationing def
limits imposed by senior management
capital rationing def
limit set on the amount of funds available for investment
with capital rationing need to select a group of projects which:
- is within the company’s resources and
- gives the highest NPV
Profitability index def
pick projects that give the highest NPV per dollar of investment
PI = NPV/ initial investment
hard rationing def
limits imposed by the unavailability of funds in the capital markets
