Finance 4

Question 1

what is the internal rate of return, IRR

Answer 1

• the minimum rate of return an investment can generate on its own
• aka, the discount rate at which an NPV calculation = 0

Question 2

what is the significance of the IRR

Answer 2

• an investment should be accepted if the IRR exceeds the required rate of return
• an investment should be rejected if the IRR is less than the required rate of return

Question 3

what are the 3 pitfalls with IRR

Answer 3

• having multiple rates of return for one investment
• comparing mutually exclusive investment opportunities
• sometimes it is impossible to determine the IRR

Question 4

what are the 5 other additional tools that can be useful in the capital budgeting evaluation process

Answer 4

• payback period
• discounted payback period
• profitability index
• economic value added (EVA)
• market value added (MVA)

Question 5

what is the payback period

Answer 5

• the length of time a project needs to recover an investment
• the time value of money is not considered in this case
• the cut-off period determines if the project should be accepted or rejected

Question 6

what are the pros of the of the payback period method

Answer 6

• easy to understand
• favors liquidity
• allows efficiency in making decisions

Question 7

what are the cons of the payback period method

Answer 7

• ignores the time value of money
• ignores cash flows beyond the cut-off date
• biased against long-term projects like R&D

Question 8

what is the difference between the payback period and discounted payback period method

Answer 8

• the discounted payback period method takes the time value of money into account
• making the method more rigorous
• but it still neglects cash flows after the cut-off date

Question 9

what is the formula for the profitability index

Answer 9

• profitability index = NPV / initial investment

Question 10

what is the disadvantage of the profitability index method

Answer 10

• the method breaks down when theres more than one resource to be rationed

Question 11

what is economic value added

Answer 11

• an estimate of true economic profit
• as it takes into consideration the charges of the capital invested in the firm

Question 12

what is the formula for economic value added, EVA

Answer 12

• EVA = NOPAT - capital charge
• capital charge = cost of capital * capital employed, C0

Question 13

what is the significance of the economic value added

Answer 13

• if the return on an investment cant cover the cost of capital, the investment should be rejected
• if the return on an investment can cover the cost of capital, the investment should be accepted

Question 14

what is market value added, MVA

Answer 14

• an extension of the EVA
• you use all the EVAs calculated over a period of time
• and you discount these future EVAs by the cost of capital to get their PV equivalent

Question 15

out of all the decision making tools that have been explored, what is the hierarchy

Answer 15

• NPV is always the primary decision making tool
• IRR and the rest are secondary options

Question 16

what is the formula for the weighted average cost of capital, WACC

Answer 16

• WACC = E/Vr_e + D/Vr_d*(1-T)
• E = equity
• D = debt
• V = total market value of firms capital (equity+debt)
• r_e = cost of equity
• r_d = cost of debt pre-tax
• T = tax rate