Investment Decition Rules Flashcards
What decides if an investment is worthwhile
Net present value
What is the npv rule
If nov is positive invest in the largest npv
How do you calculate the nov of a perpetuity with an initial cost
Annual gain divided by interest rate or other cost if capital subtracted by the initial cost
If the real rate is higher than IRR should you make the investment
No
What is the IRR rule
Invest when the IRR is higher than the cost of capital
What is cost of capital
The return of securities or projects with equivalent risk
What is the requirement for the IRR rule to worke
That all the negative cashflows preceded the positive and that there is precisely one solvable IRR
What is the payback rule
That you should choose the investment that pays back its cost the fastest and only invest if you get back your money within a time leriod
Why does the payback method work poorly in financial decision making
Because it ignores discount rate and payments after payback also the payback period is often determined in an arbitrary way
What may prevent you from choosing the project with the highest npv
Budget constraints
What is a profitability index
PI = npv/cost
npv in relation to the resources consumed
How do you make decisions using the profitability index
Sort the investments with the highest pi at the top and invest from tip to bottom until you reach the budget cap or the nov of the investments are negative
When does the PI rule work porely
You should not be able to choose more projects after you apply the pi rule and there should only be one limited resource
What is IRR
Investment return rate which is the interest rate required for the investment to pay off in present value
