Decision Making Flashcards
What is a discount rate
A rate for converting money of one year from now into present money
How to sum money received at different dates
Use a discount rate
The discount rate depends on
Tthe alternatives that the company/individuals have at hand. Therefore its different for each person/company
Two companies have the same discount rate (True/False)
False. Different companies/persons different discount rates
If your discount rate is high, what happen with the present value of future wealth
It will tend to be smaller
FV/ (1+r) = PV.
Since it is a fraction if r is greater =whole fraction become smaller
In which situation you will need to invest less money today to get 100 in 1 year:
A. r= 10%
B. r= 5%
A
Which ratio does the companies usually use as their discount rate
ROI (return on investment)
The discount rate is not the same as
The cost of capital
If an investment has cash flows (Fo, F1,…, Ft) at years t=0, t=1,…, t=T, then the NPV of this investment at a discount rate r is
NPVr = Fo + F1/1+r + F2/(1+r)^2
Usually Fo will be negative (but not always).
What NPVr represents
NPV= how much additional money would you receive if you invest in the project rather than investing at your discount rate
What parameters do we need to calculate the NPVr of a project
- Always need a discount rate, since different discount rates will produce different NPVs
- Initial investment (“sunk costs”)
- Future cashflows for the project
Meaning of NPV20= 47.2
r= 20
You will be EUR 47.2 richer TODAY than if you had invested at your discount rate
NPV is always expressed in
Monetary values (EUR, US)
NPV depends on
The initial investment. Large initial investments lowers NPV´s
Given your discount rate r, when do you invest
NPVr > 0 It means that the sum, in present terms, of all the cash flows associated with the investment is positive
Given your discount rate r, when you DON´T invest
NPVr < 0
What a positive NPV means
It means that the sum, in present terms, of all the cash flows associated with the investment is positive and therefore the investment should be undertaken
The internal rate of return (IRR) of an investment is
The discount rate for which the NPV = 0
What does it mean that an investment has a IRR of 25%?
We could picture the investment as a machine that converts each 100 euros we invest today in 125 euros one year later
If the discount rate in your company is 20% what does it mean?
For your company 100 euros now is equivalent to 120 one year from now. Conversely, 120 one year from now is equivalen to 100 euros today
How do you use the IRR as an investment decision rule
If IRR of a project > r (discount rate) of your company =take the project
If IRR of a project < r = reject the project
How do you calculate the IRR?
- Trial and error: Calculate the NPV of the project using different discount rates until you get NPV=0. Remember that if the NPV>0 you have to keep increasing the discount rate
- Using IRR formula in Excel
In which situation a project may have multiple IRR´s. What are the implications?
When a project has an initial outflows, then several inflows and a posterior outflow. In this case we can´t use IRR as a decision criteria
When can we use the IRR>r criteria to choose a project
For projects with an initial outflow and then several inflows WITH NO POSTERIOR OUTFLOWS
Which project does we choose:
NPVr ofProject A > NPVr of Project B
but…
IRR Project B > IRR Project A
Always choose the project with the highest NPV, in this case Project A
If the NPVr > 0 then the IRR is
IRR> r when the NPV graph is decreasing
Which investment would you choose and why
A: NPV= 2333 IRR =66%
B: NPV 1366 IRR=78%
Investment A, higher NPV, then the project worth more than B, despite the fact that B has a higher IRR
How depreciation affects NPV calculations?
In two ways
- It must be taken as an expense to calculate taxes on net income
- However since it is not an actual cashflow it must be added back to net income to calculate cashflows for NPV
How working capital affects NPV calculations?
In two steps
- It must be taken as a sunk cost at the beginning of the project (negative sign)
- At the end of the project it is added back
This is only true if we have a clear end of projects
Which cashflows are used to calculate NVP a project?
All cashflows: operational, financial and investing
