Investment Decision Rules Flashcards
What is the NPV Investment Rule?
When making an investment decision, choose the alternative with the highest NPV
When is a project worth investing in according to NPV?
When the NPV is greater than 0
What is an NPV Profile?
-A graph of a project’s NPV over a range of discount rates
-Where graph crosses x-axis is the IRR
What is the key decider of NPV?
The cost of capital
What is the IRR of a project?
-The discount rate that sets the NPV to 0
-Provides useful information regarding the sensitivity of a project’s NPV to errors in cost of capital estimates
What is the difference between the cost of capital and iRR?
The maximum estimation error in the cost of capital that can exist without altering the original decision
What is the IRR rule?
-If the IRR is greater than the cost of capital then an investment opportunity should be taken
-The cost of capital is the return on other alternative investments in the market with equivalent risk and maturity
What are three instances where the IRR rule will not work?
-Delayed investment
-Multiple IRR (Think x^2 graph)
-No IRR (dy/dx=0, d^2y/d^2x >0, y>0)
What is the Payback rule?
Only accept a project if its cash flows pay back its initial investment within a pre-specified period
What is the calculation process for the payback rule?
Calculate the payback period and see if this is less than the pre-specified period
What are the main flaws to using the payback method?
-Ignores the cost of capital and time value of money
-Ignores cash flows after the payback period
-Relies on arbitrary, ad hoc devision criteria
Why is the payback rule still used, despite its flaws?
-Simplicity
-Useful for smaller investments where doing an NPV or IRR calculation is not warranted
What is the best decision rule to use when comparing projects?
NPV
What are the scenarios where the IRR of projects cannot be meaningfully compared?
-Differences in Scale- % so absolute returns are not discernable
-Differences in timing- Projects with different timings of cash flows may be ranked differently
-Differences in Risk: IRR ignores risk differences
What is the incremental IRR?
The discount rate at which it becomes profitable to switch from one project to another
What are the drawbacks of using the incremental IRR?
-Does not account for timing of cash flows
-Does not indicate whether either project has a positive NPV
-When projects have different costs of capital it is not obvious which rate the incremental IRR should be compared to
What is the equation for profitability index?
-Value Created/ Resource Consumed= NPV/ Resource Consumed
-This is the NPV per unit of resource consumed
What two conditions must be satisfied for the profitability index to be reliable?
-The set of projects completely exhausts the available resource
-There is only a single relevant resource constraint
