L12 - Investment Decisions Flashcards
What is the definition of the Opportunity Cost of Capital?
The return foregone from a certain investment activity instead of investing to an alternative activity (with the same level of risk).
- If you invest in property instead of buying bonds, then the interest rate on bonds, say r , is the opportunity cost of capital.
What is the decision rule for Net Present Value?
Accept invesmtents that yield positive NPV –> they are increasing the value of our corporation
What is the Profitability Index?
Ratio of NPV to cost of investment e.g. PI = NPV/Q
- lnteresting when funds are limited to invest in all projects with + NPV (capital rationing). –> want to look at alternative criteria to supplement the NPV decision
- Pl picks projects with highest NPV per £ of initial investment.
What are Pitfalls of the Profitability Index?
- possible bias against costly projects… although they may have a larger NPV.
- resources/funds can be constrained in more periods.
- cannot cope with mutually exclusive projects (eg: require the same piece of land, but different useful life), –> different ways to produce an item which produces different cashflows over different time periods
- or when one project is dependent on another (eg: one is an add-on to the other).
What is the Book Rate of Return (BRR)?
- Prospective book income as a proportion of the book value of the assets that the firm is proposing to acquire:
- BRR= book income/book assets
- Its an accounting measure of the of the return of an investment. Book being what the account has on its financial position and income sheets
What are the Pitfalls associated with the Book Rate of Return?
- bias against more costly projects even with higher NPV;
- average profitability of past investments (book rate of return) is not the right hurdle for new investments; –> when we have a new investment we calculate its specific book rate of return against the average that is already being generated –> past performance does indicate what current and future performance will be
- depends on which items the accountant treats as capital investment (and how rapidly they are depreciated) and which items are operating expenses (training, R&D, marketing etc. which financial managers would consider investments but accountants say its expenses) ;
- therefore, an accountant’s classification of cash flows, may yield different results (accounts discount assets and cashflows every year using straight line/reducing balance method whereas financial managers just discount with time)
What is the Payback Method?
Payback period: measures 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.
- this is good for smaller companies that cannot not easily assess sources of finance - may have cashflow problems therefore they would want their money back as soon as possible
- However this may lead to a agency problem where managers pick projects with the better Payback period as it makes them look good but shareholders would want long term growth with better future cashflow potential
What are the Pitfalls of the Payback Method?
- all cash flows after the cut-off date are ignored (although they may be significantly high); –> cashflow may not pick up to later which would give a better NPV
- all cash flows before the cut-off date are treated equally (without taking account of discounting). –> only looking at the absolute value and does not account for the time value of money
- Some companies therefore use discounted payback –> where they discount the cashflow first before calculating the payback period
How do you calculate Internal Rate of Return?
- Rearrange the equation when NPV = 0 to get the IIR discount rate
- r is the oppounity cost of capital –> what you would get from investing in the financial markets
- IIR is a measure of profitability of the Investment project
- It is hard to compute accurately especially with more than 2 cashflows thus need a trial and error approach to figure it out (use Lecture 4 for formula)
What does NPV look like on a graph?
What are the Pitfalls of the Internal Rate of Return?
- Its difficult to compute by hand
- the problem with borrowing
- projects that incur some future cost
- more than one opportunity cost
- it can be misleading with mutually exclusive projects
How does borrowing lead to a problem with IIR?
- Borrowing of Cashflow in first period of Project B –> it changes our rule - accept when r > IIR instead
how do futures costs cause a problem with IIR?
- there may be multiple IIRs or even none –> so which one doe we use? do we accept NPVs between the IIRs or find the maximum NPV discount rate?
- e.g. some firms may incur a future cashflow after a investment project as they may need to decommission a factory
How does multiple opportunity costs cause a problem for IIR?
How does mutually exclusive projects cause a problem with IIR?
- we are producing one product in two different ways
- how do we compare the two projects with different initial costs and cashflows at different times ?
- internal rate of return on the incremental flows –> calculate the different between the cashflows and calculate its own NPV
- tells us which one we prefer between two options
Proof that NPV and RR as qualitatively equivalent?
