Chapters 2&3: Decision Rules Flashcards
Three processes in any cash-flow analysis
- Identification
- Valuation
- Comparison
Conventions in representing cash flows
- Initial or ‘present’ period is always year 0
- Year 1 is one year from present year
- All amounts accruing during a period are assumed to fall on the last day of the period
Comparing costs and benefits
- We cannot compare dollar values that accrue at different points in time - to compare we use the concept “discounting”
- Reason: $1 today is worth more than $1 tomorrow
Discount Factor
1/(1+i)^n
Future Value
FV=PV*(1+i)^n
Present Value
PV=FV/(1+i)^n
Net Present Value
Found by subtracting the discounted value of project costs from the discounted value of project benefits
NPV Decision Rule: Accept vs Reject Decisions
If NPV =>0: accept
If NPV<0: reject
Choose larger NPVs
Changing the discount rate
As the discount rate increases, the NPV increases
IRR
the discount rate at which NPV=0
The IRR decision rule
Compare the IRR to the cost of borrowing funds to finance the project
- If IRR=>r: accept
NPV vs IRR
- With straightforward accept/reject decisions, the NPV and IRR will always give identical decisions
- Safer to use NPV rule when comparing or ranking mutually exclusive projects
Other problems with IRR
- Multiple solutions
- No solution
Using Annuity Tables
When there is a constant amount each period, we can use an annuity factor instead of applying a separate discount factor each period
Problems with NPV Rule
- Capital rationing (more projects may pass NPV test than you can fund) -> use profitability ratio
- Indivisible or “lumpy” projects -> compare combinations to maximise NPV
- Projects with different lives -> renew projects until they have common lives using LCM; use annual equivalent method (using annuity factors, convert stream into a constant annual amount)
