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Financial Economics > E2: Investment Decisions > Flashcards

E2: Investment Decisions Flashcards

1
Q

Name the 6 investment decision criteria.

A

NPV
PI (profitability index)
Book RoR
Payback Period
IRR
RoR

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2
Q

You would invest if NPV is…

A

Positive

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3
Q

An investment is more optimal the …. the PI is

A

Higher

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4
Q

How can BRR be used to help determine what to invest in?

A

Comparing BRR of project with BRR company currently earns

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5
Q

For an investment to be worth it the payback period must….

A

be within a specified period (when a company need / wants it back)

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6
Q

You should accept an investment if IRR …

A

is larger than opportunity cost of capital. IRR > r

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7
Q

You should accept an investment if RoR is …

A

larger than opportunity cost of capital. > r

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8
Q

r is the interest rate, what is it also when thinking about investments?

A

opportunity cost of capital

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9
Q

How do you calculate the NPV?

A

PV - cost of investment (Q)

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10
Q

How do you calculate the PI?

A

PI = NPV / Q

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11
Q

What are some pitfalls of PI?

A
  • possible bias against costly projects despite a higher NPV
  • ineffective with mutually exclusive projects
  • resources/funds can be constrained in more periods
  • or when one project is dependent on another
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12
Q

How do you calculate BRR?

A

Book income /book assets

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13
Q

What are some pitfalls of the BRR?

A
  • bias against more costly projects with higher NPV
  • average profitability of past investments is not the right measure for new investments
  • subjective on which items the accountant treats as capital investment and which are operating expenses
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14
Q

Pitfalls of the payback measure?

A
  • all cash flows after the cut-off are ignored
  • all cash flows before the cut-off are treated equally
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15
Q

What is IRR?

A

the rate of discount that makes NPV = 0

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16
Q

How do you calculate present value?

A

PV = Ct/ (1+rt)

17
Q

What are some pitfalls of the IRR measure?

A
  • can sometimes lead to choosing negative NPV projects when used in the case of borrowing (postitive initial inflow, negative future)
  • when project incurs some future costs, there may be multiple IRRs or none!
  • hard to calculate with multiple opp costs of capital
  • misleading with mutually exclusive projects
18
Q

Difference between IRR and RoR?

A
  • RoR is the ratio of the project’s profitability
  • IRR is the discount rate when a project’s NPV is 0
19
Q

How do you calculate RoR?

A

RoR = (C - Q) / Q

20
Q

How do you solve for IRR?

A

Ct/ (1+IRR)t - Q =0

21
Q

What is the typical measure of how preferable an investment decision is?

A

NPV

Financial Economics (11 decks)

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