Lecture 2

Question 1

What is NPV?

Answer 1

NPV is the sum of present values of all cash flows (including the one at time 0)

Question 2

NPV Rules

Answer 2

If NPV = 0 or more, reject the project
If NPV = <0, accept the project

Question 3

Pro’s of NPV approach

Answer 3

• Takes into account the time value of money
• Takes into account the investment size
• It can handle non-conventional cash flows

Question 4

Con’s of NPV approach

Answer 4

• Prediciton on future cash flows could be inaccurate
• It assumed future cash flows aren’t subject to change
• The result of the NPV approach could contradict other approaches

Question 5

What is IRR?

Answer 5

IRR is mathematically the discount rate (r) which makes the NPV of a project equal to zero. It is referred to as the yield of a project.

Question 6

IRR Rules

Answer 6

• If IRR < R, the project should be rejected
• If IRR = 0 or more, accept the project

Question 7

Con’s of IRR

Answer 7

• Multiple solutions
• Ranking issues
• Confusion over investing/financing type decisions

Question 8

What is payback?

Answer 8

Payback is the process that cumulated cash inflows cover the initial cash outlay.

Question 9

What is payback period?

Answer 9

Payback period is the length of time that future cash flows equal the initial cash outlay.

Question 10

Payback Rules

Answer 10

• For projects with predetermined time limits, the if the payback is less or equal to the threshold the project should be accepted.
• If the project is longer than the time limit it should be rejected
• Projects where future cash flows cannot cover the initial cash outlay should also be rejected

Question 11

Simple Payback

Answer 11

Measures the number of years that future cash flows equals or exceeds the initial cash outlay.

Question 12

Discounted Payback

Answer 12

Future cash flows are discounted prior to calculating the payback period. It takes into account the time value of money.

Question 13

Popularity of payback method

Answer 13

• A secondary method for decision making
• Easy to communicate
• Can be used at early stages to filter out faulty projects
• Can be used when a firm is in situations of capital shortage

Question 14

Profitability Index Approach

Answer 14

A method to make project investment decisions. It is the ratio of sum of PV’s of all future cash flows divided by the absolute value of initial cash outlay.

Question 15

Profitability Index Rules

Answer 15

• Accept the project if PI>1
• Reject otherwise

Question 16

Profitability Index Rules (mutually exclusive projects)

Answer 16

• Accept the project that has the highest PI
• Reject other remaining projects
• We follow NPV approach if it contradicts the PI result

Question 17

Equivalent Annual Cost (EAC) Method

Answer 17

The PV of total costs of the asset (NPV of all costs) is equated to a N year (n=Life of asset) ordinary unit. We then compare the annual payments amongst assets and choose the lowest annual payment.

Question 18

Types of Real Options

Answer 18

• Options to expand
• Options to abandon
• Timing options - potential for a project to generate future value but not at the current time