Financial decision models Part 2 Flashcards
The internal rate of return
(IRR) is the discount rate that produces _______________.
A net present value of zero
The internal rate of return is defined as the technique that ___________________________
determines the present value factor such that the present value of the after-tax cash flows equals the initial investment on the project.
What is the formula for Internal Rate of Return (IRR)?
STEP 1
Net Incremental investment (investment required) / Net Annual Cash flows = Factor of the IRR
STEP 2
Locate the factor derived above to identify the rate of return it represents.
What is an internal rate of return?
A. A net present value.
B. An accounting rate of return.
C. A payback period expected from an investment.
D. A time-adjusted rate of return from an investment.
Choice “D” is correct.
The internal rate of return is one of many capital budgeting techniques that utilize present value concepts to value both the investment and the related cash flows. These methods are generally referred to as using a time-adjusted
rate of return.
Which of the following events would decrease the internal rate of return of a proposed asset
purchase?
A. Decrease tax credits on the asset.
B. Decrease related working capital requirements.
C. Shorten the payback period.
D. Use accelerated, instead of straight-line depreciation.
Choice “A” is correct
RULE:
The internal rate of return is computed as follows:
Investment / Cash Flows = Present Value Factor
The higher the present value factor, the lower the computed rate (internal rate of
return). Increases to the investment or decreases to the cash flows serve to increase
the present value factor.
A decrease in tax credits associated with an asset would increase the initial investment. That increase would cause the present value factor to increase
and would result in a decline in internal rate of return.
Does a decrease in working capital leads to an INCREASE or DECREASE of the following?
Initial Investment Amount?
Present Value Factor?
Internal Rate of Return?
Initial Investment Amount - DECREASE
Present Value Factor - DECREASE
Internal Rate of Return - INCREASE
A reduced payback period correlates to a(n) ____________ in the present value factor.
decrease
Decreases in the present value factor is in a(n) _____________________ in the internal rate of return.
increase
Which of the following is a valid method of calculating the internal rate of return?
A. Calculate the present value of each cash flow for each year and subtract it from the cost of the investment.
B. Plot three or four combinations of net present value (NPV) and discount rate on a
graph, connect the points with a smooth line, and locate the discount rate at which NPV = 0.
C. Calculate the project net income for each year, and then compute a simple average. Average the project’s beginning and ending book value. Divide the average net income by the average book value.
D. Compute the total of the present values of each year’s cash flow. Divide the total of the present values by the initial investment.
Choice “B” is correct.
The internal rate of return (IRR) is the expected rate of return on a project. The IRR will determine the present value factor and related interest rate that
yields a net present value (NPV) of zero.
Plotting the discount rates and net present values on a graph and locating the rate at which the NPV is zero is a valid way of calculating the IRR.
Preston Corporation is evaluating its potential investment in a $225,660 piece of equipment
with a three-year life and no salvage value. The company anticipates that pre-tax cash
flows in each of the three years will equal to 22%, 44%, and 66%, respectively, of the
investment’s face value. The tax rate is 28%. Pre-tax cash flows, discounted at 10 percent, are $427,697, undiscounted after-tax cash flows are $279,185, and after-tax cash flows, discounted at 10 percent, are $225,660. The internal rate of return is:
A. 10.0%
B. 22.0%
C. 23.7%
D. 44.0%
Choice “A” is correct. The internal rate of return is equal to the discount rate at which the net present value of the investment is equal to zero. The $225,660 present value of after-tax cash flows associated with the investment discounted at 10% is equal to the value of the investment. The internal rate of return is 10%.
The rankings of two mutually exclusive investments determined using the internal rate of
return (IRR) method and the net present value (NPV) method may be different in which of
the following situations?
If the two projects have unequal lives and the size of the investment for each
project is different.
The internal rate of return (IRR) is the expected rate of return of an investment, and the net present value (NPV) produces the expected dollar return on
an investment. The two methods will in most cases produce the same investment decision, but they may differ if the projects have unequal lives and the size of the investment differs for each project.
Under which one of the condition is the internal rate of return method less reliable than the net present value technique?
When there are several alternating periods of net cash inflows and net cash outflows.
The internal rate of return (IRR) method is less reliable than the net present value (NPV) technique when there are several alternating periods of net
cash inflows and net cash outflows or the amounts of cash flows differ significantly. The IRR is strictly a percentage measure of return, while the NPV is an absolute measure. Due to this difference, the timing or amount of cash flows under IRR can be misleading
when compared to the NPV method.
Example:
If an investment of $50 earns $100. Then, 100/50 = 200% return
If an investment of $50,000 earns $25,000 then, 25,000/50,000 = 50% return
IRR suggests it is best to invest $50 to earn $100 and a 200% return while the NPV method will favor a larger NPV for the $50,000 investment.
When evaluating capital budgeting analysis techniques, the payback period emphasizes:
A. Liquidity.
B. Profitability.
C. Net income.
D. The accounting period.
Choice “A” is correct. - LIQUIDITY
The payback period is the time period required for cash inflows to recover the initial investment. The emphasis of the technique is on liquidity (i.e., cash
flow).
If given Annual revenue, Total operating cost, payback period, and depreciation:
What is the formula to calculate the initial investment using the payback-period method?
NOTE: assume tax rate is NOT a factor and not given here.
Total Operating Expense
+
Depreciation
= Total Cash Flows (NOTE: no tax rate provided)
Total cash flow x Payback Period = Initial Investment Amount.
Ex/ 32000 cash flows x 5.2 years = $166,400 initial investment.
To calculate Payback period, should one use “Annual Cash Flows” OR “Annual Net Income”?
ANNUAL CASH FLOWS