lec 6 Flashcards
opportunity cost of caputal
WACC (MARR) for project selection -> IRR must be greater than that
conventional CF
All on the same side (same amount, same sign)
What happens to IRR if CFs non-conventional
Can produce multiple IRR
if IRR used as discount rate, PI equals
1 bc PI = 1- PVR ->PVR = 0
Crossover point or point of indifference
Where NPVs of two projects are equal
payback period
DPP = last year when CUM DIS CF was negative - preproduction number of years + abs(last CumDCF)/next DCF
If a discount rate is greater than IRR, what happens to NPV
NEgative NPV, initial investment greater than market value of the project
Payback Period (PP) disadvantages
Ignores cash flows after payback period,
does not consider time value of money or CF timing,
does not measure investment efficiency.
Discounted Payback Period disadvantages
Ignores cash flows beyond payback period,
does not measure investment efficiency.
Accounting Rate of Return (ARR) disadvantages
Based on accounting values rather than cash flows,
ignores time value of money, timing of CFs.
Net Present Value (NPV) disadvantages
Does not measure investment efficiency, can be difficult to compare projects with different scales.
Advantage: measures absolute wealth creation of a project
Profitability Index (PI) disadvantages/ad
+ measures investment efficiency
+ useful tool for limited funds
Present Value Ratio (PVR) disadvantages/advantages
+ measures investment efficiency
+ useful tool for limited funds (PVR helps prioritize projects that yield the highest return for each dollar of investment. This is crucial when funds are scarce and must be allocated efficiently.)
Equivalent Annual Value (EAV) disadvantages
Assumes an indefinite project requirement, not useful for short-term projects.
does not measure investment efficiency.
Benefit-Cost Ratio (BCR) characteristics
Relies on correct estimation of social benefits and costs, sensitive to discount rate assumptions.
Magnitude of BCR changes with respect to how certain components
are classified, e.g. a reduction in cost to the government as opposed to a reduction in benefits to society. Thus, the BCR should not be used as a project ranking tool.
Internal Rate of Return (IRR) disadvantages
Can give multiple values if cash flows change signs multiple times, assumes reinvestment at IRR which may not be realistic. (more than one sign switch)
Or no IRR (same side)
Total cashflow disavantages
ignores TVM, CF timing and project life
Does not measure investment efficiency
What is the formula for Cash Flow (CF)?
CF = Revenue - OpEx - Taxes - CapEx
CF = NI + Dep + other non cash allowances - Cap Ex
What is the formula for Accounting Rate of Return (ARR)?
What want?
ARR = Average Annual Net (After-tax) Income / Average Capital Investment
Want: higher ARR
How is Average Capital Investment calculated?
Average Capital Investment = (Initial Investment + Final Investment) / 2
What is the Discounted Payback Period?
Uses present values of CFs instead of actual CFs.
want shortest PP or DPP
What is the formula for Net Present Value (NPV)?
NPV = ∑ (CF_t / (1 + i)^t)
Where i is miminum accepted rate of return (usually WACC)
Accept if NPV> 0
What is the formula for Profitability Index (PI)?
PI = 1 + PVR or PI = Discounted Production CFs / Discounted Pre-production CFs
want PI >= 1
What is the formula for Present Value Ratio (PVR)?
PVR = NPV / Discounted Pre-production CFs
Want PVR >= 0
What is the formula for Equivalent Annual Value (EAV)?
EAV = NPV × (A/P, i, n)
convert NPV to an annuity
Want EAR >= 0
What is the formula for Benefit-Cost Ratio (BCR)?
BCR = PW(Benefits) / PW(Costs) = REV +SV / (Cap EX + Op Ex + Tax)
want BCR >= 1
What is the Internal Rate of Return (IRR)?
The discount rate that makes NPV = 0.
want IRR >= MARR
What is the formula for Weighted Average Cost of Capital (WACC)?
WACC = Cost of Equity × Weight of Equity + Cost of Debt × Weight of Debt × (1 - Tax Rate)
Required rate of return
The required rate of return or discount rate in these problems represents the minimum return needed to make this project a worthwhile investment compared to other available options.
Capital gain
growth of company g
what do you do when you have independant projects
Just check if theyre acceptable, not incremental
-> do regular IRR > WACC or NPV>0
current dividend
D_0
