Investment Criteria Flashcards
Net present value - decision rule
- if the NPV is positive the investment opportunity provides a return greater than the firms cost of capital and creates value for the shareholders;ding
- if the NPV is negative the investment opportunity provides a return less than the firms cost for capital and loses value for the shareholders (economic value)
Decision criteria test
Does the NPV rule account for the time value of money? Does the NPV rule account for the risk of the cash flows?
Does the NPV rule provide an indication about the increase in value?‹#
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Comm203
Should we consider the NPV rule for our primary decision criteria?
The payback rule
The payback period is the length of time it takes for an investment to generate cash flows to recover the cost of the initial investment.
➢ How long does it take to get the initial cost back in a nominal sense?
Based on the payback rule, an investment is acceptable if its
calculated payback is less than some pre-specified number of years.
Advantages of the payback rule
Advantages of payback rule:
Easy to use and understand
Biased towards liquidity
Adjusts for uncertainty of later cash flows…by completely ignoring them!
Disadvantages of the payback rule
Disadvantages:
Ignores time value of money
Ignores project specific risk
Cutoff point is arbitrary
Ignores cash flows beyond the payback period
Biased towards ST projects such as research & development and new projects
The discounted payback period
is the length of time until the sum of the discounted cash flows equals the initial investment.
- An investment is acceptable if its discounted payback is less than some prescribed number of years.
- Unlike the payback, the discounted payback is the time it takes to break even in an economic or financial sense.
Discounted payback - advantage
An investment is acceptable if its discounted payback is less than some prescribed number of years.
Unlike the payback, the discounted payback is the time it takes to break even in an economic or financial sense.
Disadvantages
Ignores cash flows after the cutoff point
May reject positive NPV projects
Requires an arbitrary cutoff point
Biased against LT projects like R & D and new projects
The internal rate of return
- The IRR is the discount rate that makes the NPV equal to zero.
- This rate is an internal rate in the sense that it depends only on the cash flows of a particular investment, not on rates offered elsewhere.
- This is the most important alternative to NPV.
- Based on the IRR rule, an investment is acceptable if the IRR exceeds the required rate of return; it would be rejected otherw
In internal rate of return
The NPV and IRR rules always lead to identical decisions if:
Cash flows are conventional (the first cash flow is negative, and the rest are positive).
The project under consideration is independent (no comparisons are made to other projects).
Advantages of IRR
Closely relates to NPV; generally leading to identical responses
The IRR is a simple way of communicating information about a proposal.
The IRR can be calculated without the use of a pre-established discount rate; unlike the NPV.
Disadvantages of IRR
Mutually exclusive projects- one project excludes the use of another- may lead to incorrect decisions
May result in multiple answers or no answer with non-conventional cash flows
Complexity in calculation
The profitability index
• The profitability index (PI) is defined as the present value of the future cash flows divided by the initial investment.
• If the project has a positive NPV, the PI will be greater than one; if the project has a negative NPV, the PI will be less than one.
• The PI measures the “bang for the buck” that is created per dollar invested.
Advantages of the profitability index
Closely related to NPV, generally leading to identical decisions.
Easy to understand and communicate.
May be useful when available investment funds are limited.
Disadvantages of Profitability Index
May lead to incorrect decisions in comparisons of mutually exclusive projects – similar to IRR problem.
