Lecture Five

Question 1

Present Value (PV) def

Answer 1

is the value today of a future value (or
cash flow)

Question 2

PV for single cash flow formula

Answer 2

PV= C * DF
-df = discount fctor

Question 3

PV Annutiy formula

Answer 3

PV = C * AF

Question 4

PV perpuity formula

Answer 4

PV= C/r = C*1/r

-r is interest r

Question 5

NPV stands for

Answer 5

Net Present Value

Question 6

NPV defintion

Answer 6

Present value of the cash inflows minus the present
value of the cash outflows

-NPV is the sum of all cash inflows (money coming in) minus the sum of all cash outflows (money going out), adjusted for time.

Question 7

Cost of capital

Answer 7

The required annual rate of return on an
investment project.

A.k.a. discount rate, required rate of
return, hurdle rate

Question 8

Why does npv matters

Answer 8

It tells us if an investment will make money or lose money.

Question 9

NPV decison rules

Answer 9

If NPV ≥ 0, accept the project (it will increase shareholder wealth).

If NPV < 0, reject the project (it will lose money).

Question 10

what is npv based off

Answer 10

NPV is based on cash flows (not profits)

Question 11

another name for cost of capital

Answer 11

Discount rate
Required rate of return
Hurdle rate

Question 12

how to know if projectis a good investment

Answer 12

If the NPV calculation shows a positive value after discounting with the cost of capital, the project is likely to be a good investment.

Question 13

what happens if the cost of capital is high

Answer 13

The higher the discount rate, the lower the present value of future cash flows.

This is why companies with high-risk investments require a higher cost of capital—because their money loses value faster over time.

Question 14

npv formula

Answer 14

NPV= C/(1+r)^t - Co

C = cash flow in year t (money received or paid)

r = discount rate (cost of capital)

t = year number

C_0 = initial investment

Question 15

example question for npv:
A construction company is considering buying land and building houses.

Costs:
Land cost = $1 million
Construction cost = $3 million
Total initial investment = $4 million (at t=0)

Future cash inflow: The houses can be sold in one year for $5 million.

Cost of capital = 10%.

Answer 15

PV =5,000,000/(1.10)^1
=4,545,455

NPV= inflow+outflow
(-1,000,000)+(-3,000,000)+4,545,455(pv)

=545,455
.NPV is positive= the project is a good investment and should be accepted.

Question 16

Mutually Exclusive Projects

Answer 16

When you must choose only one investment out of multiple options.

Question 17

example of a mutually exclusive prokect

Answer 17

A company can open only one new store, either in Location A or Location B.

Question 18

what do u chose with a mutually exclusive project

Answer 18

Decision Rule: Choose the project with the highest NPV.

Question 19

Investment Timing Decisions def

Answer 19

Sometimes, you can delay an investment and start it later

Question 20

example of an investment timing decision

Answer 20

A company needs a new IT system but can install it now or next year.

Question 21

key idea for investment timing decision

Answer 21

Even if you delay, you must discount all cash flows to time 0 (today) to compare fairly.

Question 22

decision rule for investment timing decision

Answer 22

Choose the option with the highest NPV at time 0.

Question 23

EAA Stands for

Answer 23

Equivalent Annual Annuity

Question 24

formula for EAA

Answer 24

PV/AF

Question 25

descion rule for EAA

Answer 25

Decision Rule: Choose the equipment with the lowest EAA.

Question 26

PP stands for

Answer 26

Payback Period

Question 27

PP defintion

Answer 27

The time required for a project’s cash inflows to recover its initial investment.

Question 28

PP formula

Answer 28

PP= initial investment/annual cash inflow

Question 29

decison rule for pp

Answer 29

Decision Rule: Accept the project if PP < than the target payback period.

Question 30

PP issues

Answer 30

Does not consider the time value of money . Ignores cash flows after the payback period. Not a reliable indicator for project selection. Provides no indicator as to the projects worth

Question 31

DPP stands for

Answer 31

Discounted Payback Period

Question 32

Discounted Payback Period def

Answer 32

Time for project PV of cash inflows = initial investment

Question 33

discounted payback period dpp decison rule

Answer 33

Decision Rule: Accept if DPP is less than the target DPP

Question 34

what would be accepted for dpp

Answer 34

projects with negative NPV would not be accepted as it would be impossible to compute a DPP.

Question 35

negatives of dpp

Answer 35

Remains an unreliable indicator when choosing between projects and still fails to provide an indication of a project’s worth

Question 36

IRR stands for

Answer 36

internal rate of return

Question 37

irr meaning

Answer 37

The discount rate at which NPV = 0. OR IRR is the projects annual rate of retur

Question 38

decison rule for IRR

Answer 38

If IRR > Cost of Capital, accept the project. -positive NPV If IRR < Cost of Capital, reject the project. -negative NPV

Question 39

how are returns expressed

Answer 39

Returns are usually expressed as an annual % (but this doesn’t consider time value of money)

Question 40

return equation

Answer 40

return%=profit/investment

Question 41

Multiple IRRs:

Answer 41

If a project has both positive and negative cash flows, there can be more than one IRR.

Question 42

Linear Interpolation for IRR Calculation: formula

Answer 42

IRR = A+(B-A)* NPV_A/NPV_A-NPV_B A = Discount rate used to find NPV_A B = Discount rate used to find NPV_B NPV_A AND NPV_B are the NPVs at respective discount rates.

Question 43

what does IRR lead to

Answer 43

wealth maximisation

Question 44

Capital Rationing

Answer 44

refers to a shortage of funds available for investment projects.

Question 45

two types of capital rationing

Answer 45

soft and hard

Question 46

Soft Capital Rationing –

Answer 46

Internal restrictions by management.

Question 47

Hard Capital Rationing

Answer 47

External funding limits. due to an actual shortage of funds available for investment.

Question 48

Profitability index

Answer 48

ensures the best ‘bang for the buck’ when investing

Question 49

Profitability index formula

Answer 49

PI= NPV Project/Inital Investment

Question 50

PI Decision rule

Answer 50

Choose projects with the highest PI. PI>0- proect is worthwhile

Question 51

what is PI used in e.g

Answer 51

used to rank the projects when capital is rationed