Investment decisions Flashcards
What is the relationship between NPV and Market value of an investment?
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
What does the NPV tells us?
- It is the value created by an investment
- The maximum amount an investor is willing to pay
- The difference between PV and mkt value
What is the meaning of IRR?
The discount rate of return that makes NPV = 0
After we find the IRR do we want a lower or a higher discount value for our project?
Lower, we want to stay on the left side of the graph
What does the NPV index allows us to do?
It allows us to rank projects according to their NPVs
What is the objective in the use of NPV index?
To find the combination of projects that maximize the weighted average of PV
If IRR > investor’s required return do you buy or sell?
Buy
If IRR < investor’s required return do you buy or sell?
Sell
What are the limits of IRR?
- 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
What is the MIRR?
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
What happens to NPV if a project has no IRR?
NPV is always positive
What should we do if the NPV is positively related to the return rate?
We should invert our investment decision, that is, find a rate of return that is > IRR
What is usually the cause for mutually exclusive projects?
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
What is hard rationing?
When a firm cannot obtain funds at the market’s return rate
What is soft rationing?
When there are internally imposed financial constraints by the management
What is a bullet repayment?
When the entire loan is paid back at maturity (face value, like bonds)
What is constant amortization?
Each year the borrower pays off a constant proportion of the principal
What are equal installments?
The borrower pays off the loan by a constant annuity
What are zero coupon loans?
Interest rates
What are the different types of repayments?
Bullet, constant amortization, equal installments and zero-coupon loans
What is the effective annual rate?
The real cost of the loan
What is considered in the financial analysis of investments?
Only cash flows
What are sunk costs and are they considered when taking investment decisions?
They are costs that would happen regardless of the investment, so they are not considered
What are the types of flows considered in investment decisions?
Only operating and investing, not financial (like i expenses, dividends, debt repayments etc.)
What would happen to NPV if we considered financial Cash flows?
It would skew NPV and overstate IRR
What happens to money invested in working capital?
It capitalized until the investment is discontinued
When should investment flows be recognized?
When they are incurred, not when decisions are made
