Investment Decision Rule

Question 1

What is the investment decision?

Answer 1

Invest in assets that earn a return greater than the minimum acceptable hurdle rate

Question 2

How do you calculate book rate of return?

Answer 2

Book rate of return = book income / book assets

Average income divided by average book value over project life

Question 3

What does the book rate of return ignore?

Answer 3

The time value of money

Question 4

What is the payback period?

Answer 4

Number of years before cumulative cash flow equals initial outlay

Question 5

What is the payback rule?

Answer 5

Only accept projects that pay back within desired time frame

Question 6

What does the payback period ignore?

Answer 6

Ignores later year cash flows and present value of future cash flows

Question 7

How do you calculate the payback period?

Answer 7

= no. of years full recovery + (uncovered cost / cash flow in last year before full payback)

Look at slides for example

Question 8

What is the net present value (NPV) of a project or investment?

Answer 8

The difference between the present value of its benefits and the required investment

Question 9

How do you calculate the NPV?

Answer 9

NPVo = Co + PVo = Co + Sigma[Ct / (1 +r)^t]

Question 10

What is the NPV rule?

Answer 10

Managers increase shareholders’ wealth by accepting all projects that are worth more than they cost. Therefore, managers should accept all projects with a positive net present value

Question 11

What are mutually exclusive projects?

Answer 11

Taking one investment makes the other one redundant because they both serve the same purpose

Question 12

How do you choose between mutually exclusive projects?

Answer 12

When choosing among mutually exclusive projects, calculate the NPV of each alternative and choose the highest positive-NPV project

Question 13

What is the internal rate of return (IRR)?

Answer 13

The IRR of a project is the discount rate that makes the project’s NPV = 0

Question 14

How do you calculate IRR?

Answer 14

0 = Co + [C1 / (1 + IRR)] + [C2 / (1 + IRR)^2] + …

Question 15

What is the IRR rule?

Answer 15

Managers increase shareholders’ wealth by accepting all projects which offer an internal rate of return that is higher than the opportunity cost of capital (hurdle rate).

Question 16

What is the opportunity cost of capital?

Answer 16

Expected rate of return (of the second-best investment alternative) given up by investing in a project

Question 17

What is the only calculation we will be asked for IRR?

Answer 17

Only calculating IRR of a single cash flow

Question 18

How do you decide what mutually exclusive project using IRR?

Answer 18

Choose the one with the highest IRR

Question 19

What is the relationship between NPV and discount rate?

Answer 19

Inverse relationship

Question 20

Will NPV and IRR yield consistent results?

Answer 20

For independent investments, YES
Unfortunately, for multiple especially mutually exclusive investments, NOT NECESSARILY

Question 21

What are the cases where NPV and IRR can yield different choices? (4)

Answer 21

Borrowing vs. lending
Multiple IRR (e.g. projects with disposal cost)
Mutually exclusive projects: investments of different scale
Mutually exclusive projects: timing of cash flows

Question 22

In the case of lending or borrowing, when do you accept the project?

Answer 22

NPV automatically gives the correct choice
Stick with NPV!

Borrowing when IRR is less than the opportunity cost

Question 23

If the cost of borrowing is at 50%, when is the NPV of the loan positive?

Answer 23

The NPV of the loan is positive only if the cost of capital is > 50%.

Question 24

When does multiple IRRs occur?

Answer 24

For cash flows with more than one change in sign, there will be more than one IRR or multiple IRRs.

Question 25

What is the solution to multiple IRRs?

Answer 25

NPV is more relaiable

Question 26

What is the optimal investment decision whne the project scales differ?

Answer 26

Depends on the constraints put on your capital (Capital Rationing).

Look at slides

Question 27

What is NPV and IRR biased to?

Answer 27

NPV biased to big projects and IRR biased to small projects.

Question 28

If you do not have capital rationing, what should you use to decide the investment decision?

Answer 28

NPV

Question 29

If you pick the project that has the lower cost, but higher IRR, what is the risk?

Answer 29

The biggest risk is that no other projects come along during the course of the period, and the funds stay uninvested (earning a NPV of zero).

Question 30

If you pick the project that has the lower cost, but higher IRR, what is the risk?

Answer 30

The biggest risk is that no other projects come along during the course of the period, and the funds stay uninvested (earning a NPV of zero).

Question 31

What is the risk of picking the project that has the larger cost, but the lower IRR?

Answer 31

The biggest risk is that lots of very good projects earning higher returns than B come along and you do not have the funds to accept them

Question 32

If a business has limited access to capital, has a stream of surplus value projects and faces more uncertainty in its project cash flows, what is it more likely to use to decide investment?

Answer 32

More likely to use IRR as its decision rule

Question 33

What are small, high growth companies are private businesses more likely to use for deciding investment decisions?

Answer 33

IRR

Question 34

What does the NPV assume that intermediate cash flows get used for?

Answer 34

The intermediate cash flows get reinvested at the cost of capital (discount rate)

Question 35

What does the IRR assume that intermediate cash flows get used for?

Answer 35

Assumes that they get reinvested at the IRR

Question 36

When the IRR is high and the project life is long, why is IRR inaccurate?

Answer 36

The IRR will overstate the true return on the project

Question 37

NPV or IRR?

Answer 37

NPV is usually more trustable

Question 38

If you are unsure on whether to use NPV or IRR, what alternative investment criteria can you use? (3)

Answer 38

Profitability index
Modified IRR
Equivalent annuity (not testable)

Question 39

What can be solved using modified internal rate of return?

What does it assume?

Answer 39

The reinvestment rate

CFs can be reinvested at the discount rate.

Question 40

How do you use modified IRR?

Answer 40

Look at slides

Question 41

How do you get from accounting earnings to cash flows? (4)

Answer 41

You have to add back non-cash expenses (like depreciation).
Sunk costs not to be considered.
You have to separate cash flows which are not expensed on the project (such as financing expenditures).
You have to make accrual revenues and expenses into cash revenues and expenses (by considering changes in working capital).

Question 42

What is required sometimes when calculating cash flows?

Answer 42

Discretion

Question 43

What are the basic principles underlying the measurement of investment returns? (3)

Answer 43

Use cash flows rather than earnings. You cannot spend earnings.
Use “incremental” cash flows relating to the investment decision, i.e., cash flows that occur as a consequence of the decision, rather than total cash flows.
Use “time weighted” returns, i.e., value cash flows that occur earlier more than cash flows that occur later.

Question 44

Why is the modified IRR more realistic than normal IRR?

Answer 44

Reinvested cash flows are invested at the rate of the cost of capital rather than the IRR rate.

Question 45

In words, how would you go about calculating the modified IRR?

Answer 45

Calculate the sum of all the future values of the reinvestment cash flows at the discount rate.
Now assume that the sum of above is only seen as one cash flow in the final year.
Let NPV=0, and solve for MIRR where NPV equals the initial investment plus the present value of the sum of all cash flows calculated prior.