Investment decisions

Question 1

What is the relationship between NPV and Market value of an investment?

Answer 1

NPV > Market value = it will be worth more in the future, so you want to invest it
NPV < Market value = its value will diminish, you want to sell it/ don’t invest
NPV = Market value = fair value

Question 2

What does the NPV tells us?

Answer 2

• It is the value created by an investment
• The maximum amount an investor is willing to pay
• The difference between PV and mkt value

Question 3

What is the meaning of IRR?

Answer 3

The discount rate of return that makes NPV = 0

Question 4

After we find the IRR do we want a lower or a higher discount value for our project?

Answer 4

Lower, we want to stay on the left side of the graph

Question 5

What does the NPV index allows us to do?

Answer 5

It allows us to rank projects according to their NPVs

Question 6

What is the objective in the use of NPV index?

Answer 6

To find the combination of projects that maximize the weighted average of PV

Question 7

If IRR > investor’s required return do you buy or sell?

Answer 7

Buy

Question 8

If IRR < investor’s required return do you buy or sell?

Answer 8

Sell

Question 9

What are the limits of IRR?

Answer 9

• It is based on the assumption that the money will be reinvested at the same rate, and it is unlikely that the company will be able to do so, especially in long term investments
• When a project has more than one IRR, then it is impossible to find the “right” one –> rely on NPV calculation

Question 10

What is the MIRR?

Answer 10

Modified IRR, it assumes that the firm’s return will be reinvested at the firm’s WACC, so it is a more realistic investment rate

Question 11

What happens to NPV if a project has no IRR?

Answer 11

NPV is always positive

Question 12

What should we do if the NPV is positively related to the return rate?

Answer 12

We should invert our investment decision, that is, find a rate of return that is > IRR

Question 13

What is usually the cause for mutually exclusive projects?

Answer 13

Hard rationing –> when a firm cannot obtain funds at the market’s return rate
Soft rationing –> when there are internally imposed financial constraints by the management

Question 14

What is hard rationing?

Answer 14

When a firm cannot obtain funds at the market’s return rate

Question 15

What is soft rationing?

Answer 15

When there are internally imposed financial constraints by the management

Question 16

What is a bullet repayment?

Answer 16

When the entire loan is paid back at maturity (face value, like bonds)

Question 17

What is constant amortization?

Answer 17

Each year the borrower pays off a constant proportion of the principal

Question 18

What are equal installments?

Answer 18

The borrower pays off the loan by a constant annuity

Question 19

What are zero coupon loans?

Answer 19

Interest rates

Question 20

What are the different types of repayments?

Answer 20

Bullet, constant amortization, equal installments and zero-coupon loans

Question 21

What is the effective annual rate?

Answer 21

The real cost of the loan

Question 22

What is considered in the financial analysis of investments?

Answer 22

Only cash flows

Question 23

What are sunk costs and are they considered when taking investment decisions?

Answer 23

They are costs that would happen regardless of the investment, so they are not considered

Question 24

What are the types of flows considered in investment decisions?

Answer 24

Only operating and investing, not financial (like i expenses, dividends, debt repayments etc.)

Question 25

What would happen to NPV if we considered financial Cash flows?

Answer 25

It would skew NPV and overstate IRR

Question 26

What happens to money invested in working capital?

Answer 26

It capitalized until the investment is discontinued

Question 27

When should investment flows be recognized?

Answer 27

When they are incurred, not when decisions are made