FMGLOBEP2 Flashcards
What is NPV?
Net present value = the difference between an investment’s market value and it’s cost.
⇒ Is the investment worth undertaking? The gain higher than the cost?
What is DCF valuation?
Discounted cash flow valuation = the process of valuing an investment by discounting its future cash flow.
What is the payback rule?
A method used to assess potential investments from the amount of time it takes for an investment to generate cash flows sufficient to recover its initial cost.
What is the shortcomings of the payback rule compared to NPV?
- The payback rule does not discount, thus ignoring the time value of money
- Does not include any risk differences (same calculation for very risky and less risky investments)
- It is very hard to come up with the “right” cutoff period
- Biased against long-term investments such as R&D and large-scale projects as they will pay back over longer time. If the NPV or IRR is better does not matter when using the payback rule.
What is the idea of the discounted payback rule?
First, compute the PV of each cash flow and then determine how long it takes to pay back on a discounted basis.
What is the main reason why the discounted payback rule most often is not used?
If you have to discount the cash flows anyway, the discounted payback rule is no longer faster than NPV, wherefore NPV is used as the best choice.
What are the shortcomings of the discounted payback rule?
- May reject positive NPV investments
- Requires an arbitrary cutoff point
- Ignores cash flows beyond the cutoff point
- Biased against long-term projects such as R&D and new large-scale projects
What is the AAR and how do you calculate it?
Average Accounting Return
Definition used in the book (definitions differ from book to book):
Average net income / Average book value
(average book value is inevitably affected by the choice of depreciation method)
Just as correct answer, you DO NOT CALCULATE it. Too many serious problems for AAR to be used.
What are the shortcomings/drawbacks of the AAR rule?
- It is not a true rate of return (ROR). It is instead a ratio of two accounting measures
- Ignores time value of money
- Arbitrary benchmark: The target AAR is a number drawn up from a hat like the payback period
- Instead of cash flow and market value it uses net income and book value (poor substitutes) ⇒ It looks at the wrong things.
DO NOT USE.
What is the IRR?
The internal rate of return.
The discount rate that makes the NPV = 0.
In other words, the IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate.
How do you calculate the IRR?
By trial and error, using a financial calculator or using Excel’s IRR function.
You try to figure out what return rate you should discount at for the NPV to be zero.
What should you be aware of regarding IRR results?
You are solving for the root of an equation. The equation can lead to two roots (crossing the x-axis more than once) and will thus give multiple IRRs.
⇒ Use NPV
- Non-conventional cash flows
- When projects are not mutually exclusive
In which cases is the decision using NPV and IRR the same and different?
Always the same UNLESS
- The cash flow is not conventional meaning that it starts with one negative cash outflow followed by purely positive inflows ⇒ Nonconventional cash flows
- In such cases the IRR rule breaks down completely and should be avoided as multiple rates can give NPV = 0
- The cash flow is not independent. If the decision on one investment affects the decision on another investment, the decision using the two different approaches will most likely not be the same ⇒ Not mutually exclusive projects
- The decision will depend on the required return as investment B can be better than A and vice versa at different required return rates due to different payback times ⇒ Again… Stay with NPV
For what reason is the IRR rule often preferred to the NPV rule?
IRR focuses on rates of return whereas NPV gives dollar values.
Rates of return are often easier to use for calculations.
What are the MIRR approaches?
Modified internal rate of return
- The discounting approach
a. discount all negative cash flows back to the present as the required return and add them to the initial cost (making the numbers conventional) - The reinvestment approach
a. Compounds all positive cash flows to the end of the project’s life and then calculate the IRR. - The combination approach
a. A combination of method 1 and 2 above
b. Negative cash flows are discounted back to the present, and positive cash flows are compounded to the end of the project.
What is the profitability index?
The present value of an investment’s future cash flows divided by its initial cost.
PV of cash flows / Initial cost
PV cash inflows / PV cash outflows
Benefit-cost ratio.
(problematic with mutually exclusive investments)
What does a PI index of 1.23 imply?
That for every $1 invested, we create an additional 23 cents in value.
What are the advantages and disadvantages of the Profitability Index?
- Advantages
- Closely related to NPV (generally identical decisions)
- Easy to understand and communicate
- Disadvantages
- May lead to incorrect decisions in comparisons of mutually exclusive investments
What are the differences between debt and equity?

What is incremental cash flows?
The difference between a firm’s future cash flows with a project and those without a project ⇒ Also means cash flows that are independent of the decision of the specific project are irrelevant.
“any and all” changes in the firm’s future cash flows as a direct consequence of taking the project.
Fx. keeping old machine vs. buying new
What is the stand-alone principle?
You evaluate a project based on its incremental cash flows ⇒ Completely independent from everything else.
You see the project as a “minifirm” and look at its cash outflow and inflow.
What are classic pitfalls when evaluating projects and their incremental cash flows?
- Including sunk costs in the calculation
- Forgetting opportunity costs
- Forgetting side effects (spillover effects, both good and bad)
- Forgetting costs to additional net working capital
- Including financing costs: interest, dividends, principal (this will be done when discounting the cash flow)
- Thinking “accrued”. We are using cash-based accounting to look at investment projects as we are interested in their cash flows.
What is erosion?
The cash flows of a new project that come at the expense of a firm’s existing projects.
What are pro forma financial statements?
Financial statements projecting future years’ operations














