Lecture 5 - Other investment appraisal techniques Flashcards
What is the Net Present Value (NPV) approach?
The NPV approach considers cash inflows, cash outflows, the timing of these cash flows, and the discount rate. It assesses whether a project will earn more than its cost. The decision rule is: NPV > 0 indicates a better than expected return, NPV = 0 indicates providing the expected return, and NPV < 0 indicates underperformance.
What is the Internal Rate of Return (IRR)?
The IRR is the discount rate that makes the NPV of a project equal to zero, meaning the initial outlay is equal to the sum of the present values of future cash flows.
How do you calculate IRR?
IRR can be calculated using trial and error, linear interpolation, or Excel’s built-in IRR function.
What is the decision rule for using IRR?
For comparing projects, choose the one with the highest IRR. For appraising an individual project, accept it if IRR is greater than or equal to the company’s target rate of return.
Why can’t NPV be replaced entirely by IRR?
NPV directly indicates the profit from a project, considering the company’s cost of finance. IRR only provides the discount rate at which NPV would be zero, which doesn’t always provide a complete picture for investment appraisal.
What are some problems associated with IRR?
IRR may not exist or may have multiple values, particularly for projects with non-conventional cash flows. It also doesn’t provide a direct measure of profitability like NPV.
What is the Payback Period (PBP)?
PBP is the number of years required to recover the initial investment. It is calculated by summing the annual net cash flows until the cumulative sum becomes positive.
What are the limitations of PBP?
PBP doesn’t consider the time value of money, ignores cash flows after the payback period, and doesn’t account for the size of the cash flows, leading to potentially misleading conclusions.
Why is NPV preferred over IRR and PBP?
NPV takes into account all cash flows, their timing, and the required rate of return, providing a more comprehensive assessment of a project’s profitability.
What is the NPV decision rule when NPV and IRR give different results?
When NPV and IRR give different results, the NPV decision rule should be used. NPV directly indicates the profitability of a project, while IRR provides the discount rate at which NPV would be zero.
What does the NPV result tell us about a project?
NPV indicates the direct profit from a project. A positive NPV shows that the project will generate more money than the cost of finance, making it a desirable investment.
What is an example where IRR might be misleading?
IRR can be misleading when a project has unconventional cash flows, leading to multiple IRRs or situations where IRR suggests a project is profitable even if it’s not the best option compared to other projects with higher NPVs.
What is the formula to calculate IRR using linear interpolation?
Linear interpolation is based on the relationship between NPV and the discount rate, assuming this relationship is linear. It involves forming two similar right-angled triangles in a graph of NPV against the discount rate to estimate the IRR.
How does the Excel function calculate IRR?
The Excel function calculates IRR by applying the formula =IRR(cash_flows), where cash_flows is the range of cells containing the net cash flows of the project. The function iterates to find the rate that sets NPV to zero.
What are the decision rules for Payback Period (PBP)?
When comparing projects, choose the one with the shortest PBP. For individual projects, accept if the PBP is shorter than the company’s required time for investment recovery.
Explain to me Linear Interpolation (IRR)?
