Investment appraisal Flashcards
Investment appraisal: non-discounted payback
how long to get cash back method
Investment appraisal: Net Present Value
converts stream of future revenue into a value ‘today’.
- choose capital investment and hurdle rate.
- show income stream from investment.
- work out residual value of investment
Positive NPV is good and a good comparison against other NPVs.
Investment appraisal: IRR
shows the rate of return on the investment per year
similar to NPV but the output is % return which can be compared to the hurdle rate.
Is the IRR greater than the hurdle rate? Yes - invest. No - don’t invest.
What is the hurdle rate?
The hurdle rate is the minimum rate of return a company expects from investing in something based on the cost of capital.
Factors taken into account include;
Interest rate
Risk
Opportunity cost
Proportion of debt vs. equity
The hurdle rate is also used to discount a company’s cashflow in the NPV method.
Problem: The calculation of the hurdle rate includes in it the ‘cost of equity’. This is a figure to demonstrate the premium for the risk. However this is a very subjective figure.
An angel investor mentioned the IRR and a hurdle rate of 20%.
Explain the nature and purpose of IRR and the significance of a hurdle rate.
The IRR is the Internal Rate of Return. This is the rate of return of the investment - what percentage return the company will make from investing, which is directly related to the NPV.
The hurdle rate is the minimum rate of return a company expects from investing in something, based on the cost of capital.
Factors taken into account include; Interest rate, risk and opportunity cost.
The hurdle rate is also used to discount a company’s cashflow in the NPV method.
Therefore the company can compare the IRR of an investment with the hurdle rate. If it is greater than the hurdle rate, the company would consider investing. If it is lower than the hurdle rate, the company is unlikely to invest.
Problem: The calculation of the hurdle rate includes in it the ‘cost of equity’. This is a figure to demonstrate the premium for the risk. However this is a very subjective figure.
