Investment Decisions Flashcards
Opportunity Cost of Capital
The return forgone from a certain investment activity instead of investing to an alternative activity
Net present value formula and decision rule
NPV = PV - Cost of investment
Accept investments that yield positive NPV
Profitability Index
PI = NPV/Q
PI picks projects with the highest NPV over £ of initial investment
Pitfalls of the profitability index
- Possible bias against costly projects even though they may have larger NPV
- Resources/funds can be constrained in more periods
- Cannot cope with mutually exclusive projects
- Cannot cope when one project is dependent on the other
Book Rate of Return and what does it compare
BRR = book income/book assets
Compares projects BRR with BRR company is currently earning
Pitfalls of BRR
- bias against more costly projects with higher NPV;
- an accountant’s classification of cash flows, may yield different results.
Payback Period
Measure the number of years it takes for the cumulative cash flow from the project to equal the initial investment
Payback Rule
A project should be accepted if its payback period is less than some specific cut-off period
Pitfalls of Payback Methods
- All cash flows after the cut-off date are ignored although they may be significantly high
- All cash flows before cut-off date are treated equally without taking account of discounting
IRR
The rate of discount that makes NPV = 0
IRR pitfalls
- In the case of borrowing the IRR rule works the other way round i.e., opportunity cost > IRR
- When project incurs some future costs, there may be multiple IRRs
- Where there is more than one opportunity cost of capital, obtaining the IRR becomes even more complex
- It can be misleading with mutually exclusive projects
Rate of Return
RoR = (C - Q)/Q
Accept investments that offer rates of return in excess of their opportunity costs of capital i.e. if RoR > r
