Decision Making

Question 1

What is a discount rate

Answer 1

A rate for converting money of one year from now into present money

Question 2

How to sum money received at different dates

Answer 2

Use a discount rate

Question 3

The discount rate depends on

Answer 3

Tthe alternatives that the company/individuals have at hand. Therefore its different for each person/company

Question 4

Two companies have the same discount rate (True/False)

Answer 4

False. Different companies/persons different discount rates

Question 5

If your discount rate is high, what happen with the present value of future wealth

Answer 5

It will tend to be smaller
FV/ (1+r) = PV.
Since it is a fraction if r is greater =whole fraction become smaller

Question 6

In which situation you will need to invest less money today to get 100 in 1 year:

A. r= 10%
B. r= 5%

Answer 6

A

Question 7

Which ratio does the companies usually use as their discount rate

Answer 7

ROI (return on investment)

Question 8

The discount rate is not the same as

Answer 8

The cost of capital

Question 9

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

Answer 9

NPVr = Fo + F1/1+r + F2/(1+r)^2

Usually Fo will be negative (but not always).

Question 10

What NPVr represents

Answer 10

NPV= how much additional money would you receive if you invest in the project rather than investing at your discount rate

Question 11

What parameters do we need to calculate the NPVr of a project

Answer 11

1. Always need a discount rate, since different discount rates will produce different NPVs
2. Initial investment (“sunk costs”)
3. Future cashflows for the project

Question 12

Meaning of NPV20= 47.2

Answer 12

r= 20

You will be EUR 47.2 richer TODAY than if you had invested at your discount rate

Question 13

NPV is always expressed in

Answer 13

Monetary values (EUR, US)

Question 14

NPV depends on

Answer 14

The initial investment. Large initial investments lowers NPV´s

Question 15

Given your discount rate r, when do you invest

Answer 15

NPVr > 0 It means that the sum, in present terms, of all the cash flows associated with the investment is positive

Question 16

Given your discount rate r, when you DON´T invest

Answer 16

NPVr < 0

Question 17

What a positive NPV means

Answer 17

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

Question 18

The internal rate of return (IRR) of an investment is

Answer 18

The discount rate for which the NPV = 0

Question 19

What does it mean that an investment has a IRR of 25%?

Answer 19

We could picture the investment as a machine that converts each 100 euros we invest today in 125 euros one year later

Question 20

If the discount rate in your company is 20% what does it mean?

Answer 20

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

Question 21

How do you use the IRR as an investment decision rule

Answer 21

If IRR of a project > r (discount rate) of your company =take the project

If IRR of a project < r = reject the project

Question 22

How do you calculate the IRR?

Answer 22

1. 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
2. Using IRR formula in Excel

Question 23

In which situation a project may have multiple IRR´s. What are the implications?

Answer 23

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

Question 24

When can we use the IRR>r criteria to choose a project

Answer 24

For projects with an initial outflow and then several inflows WITH NO POSTERIOR OUTFLOWS

Question 25

Which project does we choose:
NPVr ofProject A > NPVr of Project B
but…
IRR Project B > IRR Project A

Answer 25

Always choose the project with the highest NPV, in this case Project A

Question 26

If the NPVr > 0 then the IRR is

Answer 26

IRR> r when the NPV graph is decreasing

Question 27

Which investment would you choose and why
A: NPV= 2333 IRR =66%
B: NPV 1366 IRR=78%

Answer 27

Investment A, higher NPV, then the project worth more than B, despite the fact that B has a higher IRR

Question 28

How depreciation affects NPV calculations?

Answer 28

In two ways

1. It must be taken as an expense to calculate taxes on net income
2. However since it is not an actual cashflow it must be added back to net income to calculate cashflows for NPV

Question 29

How working capital affects NPV calculations?

Answer 29

In two steps

1. It must be taken as a sunk cost at the beginning of the project (negative sign)
2. At the end of the project it is added back

This is only true if we have a clear end of projects

Question 30

Which cashflows are used to calculate NVP a project?

Answer 30

All cashflows: operational, financial and investing