Investment analysis

Question 1

NPV

Answer 1

Net present value is used to determine the acceptability of an investment. The difference between the present value of cash inflows and the present value of cash outflows is called the projects net present value. NPV trace back all the net cash flow to year zero.

Question 2

Probability index

Answer 2

Used to compare two projects on a valid basis, the higher the probability index is, the more desirable is the project.

Probability index = NPV of cash inflows / Investment required

Question 3

Internal rate of return

Answer 3

Internal rate of return is the interest yield promised by an investment project over its useful life. The higher IRR is, the more desirable is the project.

Question 4

Payback

Answer 4

It is based on payback period, which is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates. The quicker the cost of an investment can be recovered, the more desirable is the investment.

Payback period = Investment required / Net annual cash inflow

Question 5

Decision rules

Answer 5

Rules for NPV:
NPV ≥ 0 the investment is acceptable
It promises a return bigger or equal to the required rate of return
NPV < 0 the investment is not acceptable
It promises a return less than the required rate of return

Rules for IRR:
IRR ≥ RRR the investment is acceptable
IRR < RRR the investment is acceptable

Question 6

Depreciation

Answer 6

Depreciation is not relevant in computing the present value of a project, because it is not an out-of-pocket cost, therefore not a cash flow.

Depreciation = (Fixed cost - salvage value) / Lifetime