Investment Decisions Flashcards
What is present value (PV) of an investment?
investment’s future cash flows are worth TODAY based on the annualised rate of return you could potentially earn on other, similar investments (discount rate)
Remember £1 today is worth more than £1 tomorrow, £1 today can be invested or saved now which yields future return
What is net present value and how is it used in investment decision making?
NPV is the difference between the PV of cash inflows and PV of outflows over period of time.
Used to calculate current value of a future stream of payments from investment and is used to determine whether investment will be profitable down the line.
Projects should only be engaged in if they have a positive NPV
Example, interest rate 2%, if you save £100 today you get £102 next year. What is future value and present value in this situation?
Future value of £100 is £102
The PV of £102 next year is £100 today
When comparing investment opportunities the rate of return or interest rate corresponds to what?
Corresponds to the opportunity cost of capital. Which is the return forgone from an investment activity that was not chosen.
example, If you invest in property instead of buying bonds the interest rate on bonds is opportunity cost of capital
What is the profitability index and what value is considered as a good investment?
Capital budgeting tool which helps whether to accept or reject a project.
Its a measure of an investments attractiveness. PI = NPV/Q. Ratio of NPV to cost of investment.
Useful tool for ranking investments as it allows to quantify amount of value per unit of investment.
PI picks projects with highest NPV per £ initially invested. PI > 1 = good investment as implies return > initial investment.
What is the main drawback of using the profitability index?
It doesn’t consider the size of the project so a large project with lower profit margins may have a lower profitability index than a smaller project with higher profit margins.
But the lower profit margins might come with higher actual profit
What is Book (accounting) Rate of Return (BRR) and how to tell whether they should invest?
Accounting measure of return on investment. Compares projects BRR with BRR company is currently earning.
BRR = Book income/Book assets
Book income = income public on report on financial statements, pre-tax income.
Book assets = value of assets in records of company = original value - depreciation.
Projects BRR must be higher Han company’s average to invest.
What are the different measures when making investment decision and compare them?
BRR, Payback, IRR, NPV, PI.
NPV rule is widely considered most favourable.
IRR is preferable to payback, BRR and PI
IRR is less easy to use than NPV but used properly gives the same answer
What is payback period and when should they invest?
Amount of time it takes to recover the cost of an investment.
Measures the number of years it takes for the cumulative cash flow from the project to equal initial investment.
Payback Rule - a project should be accepted if its payback period is less than managements desired cut-off period.
What are the main drawbacks with Payback period?
All cash flows after cut-off potion/ payback period are ignored.
All cash flows before cut-off date are treated equally. It ignores time value of money without discounting them to present value.
What is internal rate of return (IRR), when should they invest and how to calculate it?
Its the annual rate of growth that an investment is expected to generate.
Its the rate of discount that makes NPV = 0. Can find it either through NPV formula or by plotting NPV function of the discount rate.
If IRR > actual opp cost of capital i.e IRR > r, then invest.
What are the drawbacks of using IRR?
When the project incurs future costs there may be multiple IRRs or even none.
Major weakness is that is doesn’t consider projects size. IRR more likely to favour smaller projects with higher IRR but smaller actual returns.
What is the rate of return rule?
Its the ratio of the projects profitability.
The rule follows - “Accept investments that offer rates of return greater than their opp cost of capital. So RoR > r.
