Investment Decision Rules (Week 2) Flashcards
NPV investment rule [net present value] advantages
- Maximises the firm value
- Can be applied in all situations (very flexible)
- most widely used decision rule
Two alternative methods to NPV?
- Internal Rate of Return
- Payback Period
You have a budget of 100k. There are 3 projects, not mutually exclusive.
Red: costs 100k, NPV is 110k
Blue: costs 50k, NPV is 70k
White: costs 40k, NPV is 60k
What should you choose?
The combination of Blue and White. Combined costs 90k, combined NPV is 130k.
This is better than Red alone
What does the discount rate reflect (from the company’s point of view)?
The costs of the funds that it has obtained
What does the discount rate reflect (from the investor’s point of view)?
The required return for any new investment project
Another term for discount rate?
Cost of capital
Is discount rate higher or lower for riskier projects?
Higher
- The hurdle for taking on riskier projects is tougher
What is the risk-free rate?
Compensation for the time value of money.
Invetsors gave us some money to invest on their behalf. They have to be compensated for giving up some money now in return for some company profits later.
What is an ‘adjustment for risk’?
If a project is riskier. the risk adjustment is higher. The discount rate for riskier projects is higher than for safer projects.
Cost of capital calculation?
Cost of capital = risk-free rate + adjustment for risk
k = r + adjustment for risk
Another term for adjustment for risk?
Risk premium
Suppose you are deciding on an investment project.
The project costs $250 million and is expected to generate cash flows of $35 million per year, starting at the end of the first year and lasting forever.
What is the NPV in terms of k
= -250 + 35/k
The NPV of the project depends on the discount rate k. The higher the k, the lower the NPV.
Internal Rate of Return (IRR)
The IRR is the discount rate that sets the net present value of the cash flows of an investment equal to zero.
Mike is thinking of buying a machine.
The machine costs $1,000,000
The cost of capital (k) is 10%
The machine generates a cash-flow of $100,000 in Y1, which then increases 4% per year, forever.
What is the IRR of this investment? Based on IRR should Mike take this opportunity?
To set the NPV equal to zero:
1,000,000 = 100,000/ (k - 0.04)
k = 0.04 + 100,000/100,000,000 = 0.14
The IRR on this investment is 14%
14%>10%, Mike should invest
What are the limitations of IRR?
- Investment has positive cash-flow now, and negative cash-flows later
- IRR could be not unique
- IRR could just simply not exist
- Timing differences
- Risk differences
Projects A and B each have an expect life of 5 years. C has a life of 7 years.
Calculate the payback period. Based on payback rule which do you choose?
If the cost of capital is 10% what do you choose?
Payback Rule
A: $80 / $25 = 3.2 years
B: $120 / $30 = 4.0 years
C: $150 / $35 = 4.29
Choose A.
NPV: (Cal in pic)
Choose C
Example of BE analysis:
Project costs $120
Project life is 1 year
Cost of capital is 4%
What is next year’s BE level of cash flow?
-NPV = -120 + (CF/1.04)
Break even level of cash-flow is the cash flow for CF for which the NPV is exactly 0.
