Financial Decision Models: Part 2_M9

Question 1

What are the different investment decision models?

Answer 1

1. The Payback Period
2. The Discounted Payback Period
3. Internal rate of return (IRR)
4. The Net Present Value Method (NPV)

Question 2

What are the characteristics of the payback period?

1 of 4 Investment Decision Models

Answer 2

• The initial cash outlay is included in the numerator.
• Denominator: net after-tax cash flows (including depreciation and its related tax shield), but only up until the initial investment is recovered; beyond that point, depreciation is ignored.
• Focuses on liquidity and the time it takes to recover the initial investment.
• Computation ignores cash flows after the initial investment has been recovered.
• It measures return of capital in years on either a discounted or undiscounted basis.

Question 3

What is the payback period?

Net Initial Investment / Avg. Incremental CF

Answer 3

Formula
Total investment in a project/ annual cash flows = # of years it will take to gain a return of the initial investment.

• NOTE: (The technique does not consider time value of money concepts).
• Salvage value is considered as part of payback computations because it contributes to the incoming cash flow when the asset is sold.

Strength

• One of the major strengths of the payback method is that it is easy to understand.

WEAKNESSES

• Profitability is ignored.
• Does not consider cash flows for the entire project, after payback they are ignored.
• A gross method that does not consider the sources of cash inflows.
• Does not consider the time value of money.

Question 4

What is the Discounted Payback Method?

2 of 4 Investment Decision Models

Answer 4

• Considers the time value of money unlike The Payback Period Method.
• Ignores cash flows after the initial investment have been recovered.

Question 5

What are the characteristics of IRR

Internal Rate of Return

3 of 4 Investment Decision Models

Answer 5

Characteristics of IRR

• IRR is somewhat difficult to calculate.
• The IRR considers all estimated project cash flows.
• The IRR considers time value of money.
• The IRR uses PV concepts to value the investment and the related CF’s.
• IRR focuses its decision where the discount rate at PV of a project ash inflows equals cash outflows, IRR yields a NPV of zero.
• These methods are generally referred to as using a time-adjusted rate of return.
• If PV factors increase IRR decrease vice versa. There is an inverse relationship between the two of them.
• Accept the investment if IRR is greater than the managements hurdle rate.
• IRR is not NPV.
• IRR is the rate of return of all cash flows produced by the investment.

Weakness: Assuming funds can be reinvested at the initial computed IRR may not be a realistic if the IRR is unrealistically high or low.

Question 6

How to calculate IRR?

IRR= PV Factor x Interest Rate where NPV is 0

Answer 6

• 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.

Question 7

What are the characteristics of NPV?

4 of 4 Investment Decision Models

Answer 7

• Choose the investment with the highest NPV.
• Measures the amount of absolute return and not a rate.
• A positive net present value would confirm that the entity’s investment return exceeds the hurdle rate established by management,
• It does not measure the rate.
• It does not assume a hurdle rate equal to the incremental borrowing rate.
• NPV is the difference in the amount of an investment and its related discounted cash inflows.
• Will be greater than zero when IRR is higher than the hurdle rate (which is the desired rate of return, set by mgmt.).

Question 8

How to calculate NPV?

Answer 8

Calculating the PV of each cash flow and subtracting the cost of investment.

Question 9

IRR vs. NPV

Answer 9

• (IRR) method is less reliable than (NPV) when there are several alternating periods and amounts of net cash flows.
• The IRR is strictly a percentage measure of return, while the NPV is an absolute measure.
• IRR can be misleading when compared to the NPV.
• (IRR) is the expected rate of return of an investment, and (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.
• If the RRR equals the IRR, the NPV will be zero and there will be no difference in rankings.
• If RRR exceeds the IRR, the NPV will be negative and both approaches will produce the same output (that the investment should not be undertaken).

Question 10

What method to use in selecting a desired rate of return?

Answer 10

• Computing a discount rate related to the risk specific to the proposed project.
• Assigning a target rate (hurdle rate) for new projects to meet.
• Using a weighted-average cost of capital (WACC) method to determine the required rate of return.

Question 11

What is the relevant cost for make/lease or buy decisions?

Answer 11

Not Consider:

• Any proceeds or costs associated with the old facility that would be regardless of the decision to lease or buy and are not relevant.
• a lease is not selected are relevant.

Relevant Cost to Lease or Buy Decisions
* Any expense on the new facility.
* Any cost incurred in the event the lease alternative is selected and
would change.