Lecture 3 - Investment Appraisal Discounted Cash Flow Techniques

Question 1

What is the difference between discounted payback and basic payback?

Answer 1

Discounted payback discussed future cash flows and it considers time value of money.

Question 2

What is the discounted payback period?

Answer 2

This is the number of periods before the present value of prospective cash flows equals or exceeds the initial investment.

Question 3

How is the discounted payback period calculated?

Answer 3

Firstly you discount each cash flow using an appropriate discount rate (the opportunity cost of capital). This reflects the risk profile of the investment project. The cumulative cash flow can then be calculated in the same manner as it is for the standard payback calculation. Opportunity cost of capital, discount rate and required rate of return are the same terms.

Question 4

If the discounted payback meets the company’s cutoff period, the project is…

Answer 4

Accepted. If not, it is rejected.

Question 5

The discounted payback rule has the advantage that it will never…

Answer 5

Accept a negative NPV project.

Question 6

The discounted payback rule takes no account of cash flows…

Answer 6

After the cut off date, so a company that uses the discounted payback rule risks rejecting good long term projects and can easily misrank competing projects.

Question 7

The discounted payback method has the same advantages and disadvantages as for the traditional payback method (except the consideration of the time value of money). What is another disadvantage specific to the discounted payback method?

Answer 7

It requires a cut off period and this is arbitrary, there is no definitive investment signal.

Question 8

What is Net Present Value (NPV)?

Answer 8

Present value of project cash flows minus investment.

Question 9

How do you calculate the NPV?

Answer 9

Discount future cash flows first and then get the sum of the present values of all cash flows that arise as a result of the project. This represents the surplus funds earned on the project - an absolute measure of return.

Question 10

The net present value states…

Answer 10

That managers increase shareholders’ wealth by accepting projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value.

Question 11

What is the decision rule for independent projects?

Answer 11

Choose all the projects with a positive NPV.

Question 12

What is the decision rule for mutually exclusive projects?

Answer 12

Choose the project with the highest NPV.

Question 13

What are the advantages of the NPV?

Answer 13

• Considers the time value of money. it discounts future cash flows.
• Based on cash flows rather than accounting profits.
• Considers the whole life of the project.
• It uses the opportunity cost capital as a discount rate to take the risk into account.
• It should lead to maximisation of shareholder wealth.
• Theoretically, the NPV method is superior to all others.

Question 14

NPV of the project equals…

Answer 14

The increase in shareholder wealth.

Question 15

What are the disadvantages of the NPV?

Answer 15

• Difficult to explain to managers.
• Requires knowledge of the cost of capital. It is complicated to estimate an appropriate cost of capital.
• Relatively complex.

Question 16

NPV profile is a…

Answer 16

Graph of the project’s NPV corresponding to different values of the discount rate (convex). If the discount rate is less than the point stated on the graph then the NPV is positive. If the discount rate is higher than the point stated on the graph then the NPV is negative.

Question 17

What is the Internal Rate of Return (IRR)?

Answer 17

The discount rate at which the NPV of all cash flows
from an investment is zero. It represents a breakeven cost of capital. It is the exact discounted cash flow rate of return which the project is expected to achieve. It is like an expected rate of return of a project.

Question 18

If NPV is positive then IRR is…

Answer 18

Greater than than the cost of capital. The investment is earning more than the cost of capital.

Question 19

If NPV is negative then IRR is…

Answer 19

Less than the cost of capital. The investment is earning less than the cost of capital.

Question 20

If NPV is zero…

Answer 20

The investment is earning exactly the cost of capital.

Question 21

What is the decision rule for IRR?

Answer 21

Independent projects should be accepted if its IRR is greater than the cost of capital.

Question 22

What are the advantages of IRR?

Answer 22

• It considers the time value of money. It discounts future cash flows.
• It is a percentage measure of return and therefore, it is easily understood.
• Uses cash flows rather than accounting profits.
• It considers the whole life a project.

Question 23

What are the disadvantages of IRR?

Answer 23

• Interpolation only provides an estimate and an
  accurate estimate requires the use of a spreadsheet
  programme.
• It is fairly complicated to calculate. You will need to do trial and error if you do not have a financial calculator.
• It can lead to wrong decisions in mutually exclusive projects.
• It can be wrong for lending and borrowing decisions.
• There can be multiple IRRs if the cash flows are not conventional. There also may be no IRR if cash flows are not typical.

Question 24

Explain NPV vs IRR.

Answer 24

• NPV tells us the absolute measure of return whereas IRR tells us the percentage measure of return. The former is an absolute measure whereas, the latter is a relative measure.
• They give the same answer as long as the NPV of a
  project declines smoothly as the discount rate increases (conventional cash flows, cash outflows followed by cash inflows ).
• However, for mutually exclusive projects, the NPV rule is more appropriate.
• The NPV tells us the absolute increase in shareholder
  wealth as a result of accepting the project, at the current cost of capital.
• The IRR simply tells us how far the cost of capital
  could increase before the project would not be worth
  accepting.
• The NPV rule discounts cash flows at the
  opportunity cost of capital. For NPV the discount rate is the cost of capital which measures the risk of the project. This is the minimum acceptance rate set by shareholders.
• The IRR rule discounts cash flows at the IRR. This means it implicitly assumes the time value of money is the IRR. The discount rate is the IRR. It assumes that cash flows generated by the project can be reinvested at the IRR.
• This is usually referred to as the reinvestment rate
  assumption. The company will reinvest cash flows at
  the IRR for the lifetime of the project.
• If the reinvestment rate is too high to be feasible, then
  the IRR rule fails.