Investment Decision Rule Flashcards by Sophie McCusker

What is the investment decision?

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

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How do you calculate book rate of return?

Book rate of return = book income / book assets

Average income divided by average book value over project life

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What does the book rate of return ignore?

The time value of money

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What is the payback period?

Number of years before cumulative cash flow equals initial outlay

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What is the payback rule?

Only accept projects that pay back within desired time frame

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What does the payback period ignore?

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

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How do you calculate the payback period?

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

Look at slides for example

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

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

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How do you calculate the NPV?

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

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What is the NPV rule?

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

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What are mutually exclusive projects?

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

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How do you choose between mutually exclusive projects?

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

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What is the internal rate of return (IRR)?

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

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How do you calculate IRR?

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

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What is the IRR rule?

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).

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What is the opportunity cost of capital?

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

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

Only calculating IRR of a single cash flow

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How do you decide what mutually exclusive project using IRR?

Choose the one with the highest IRR

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What is the relationship between NPV and discount rate?

Inverse relationship

Will NPV and IRR yield consistent results?

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

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

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

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

NPV automatically gives the correct choice
Stick with NPV!

Borrowing when IRR is less than the opportunity cost

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

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

When does multiple IRRs occur?

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

What is the solution to multiple IRRs?

NPV is more relaiable

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

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

What is NPV and IRR biased to?

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

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

NPV

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

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).

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

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).

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

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

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?

More likely to use IRR as its decision rule

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

IRR

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

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

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

Assumes that they get reinvested at the IRR

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

The IRR will overstate the true return on the project

NPV or IRR?

NPV is usually more trustable

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

Profitability index Modified IRR Equivalent annuity (not testable)

What can be solved using modified internal rate of return? What does it assume?

The reinvestment rate CFs can be reinvested at the discount rate.

How do you use modified IRR?

Look at slides

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

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).

What is required sometimes when calculating cash flows?

Discretion

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

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.

Why is the modified IRR more realistic than normal IRR?

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

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

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.