Lecture Six Flashcards
npv
Present value of the cash inflows minus the
present value of the cash outflows.
Cost of capital
The required annual rate of return on
an investment project. A.k.a discount rate, required rate of return, hurdle rate.
Can be increased for riskier projects that require a higher return.
NPV decision rule
If the NPV is ≥ 0 then accepting the
project will increase the wealth of the shareholders
Payback period
tells us how long it takes to recover the initial investment.
payback period formula
=
AnnualCashInflow/
InitialInvestment
Discounted Payback Period
considers the time value of money.
Cash flows are discounted using a discount rate (e.g., 10% per year).
discounted payback period steps
1 Calculate the Present Value (PV) of each year’s cash flow.
2 Add them up until the total equals the initial investment.
3 Count how many years it takes.
how are returns expressed
expressed as a
percentage
return % equation
profit / investment
irr meaning
Internal Rate of Return
where is the IRR
The discount rate where NPV = 0.
IRR decison rule (lending projects)
If IRR > Cost of Capital, accept the project/positive NPV
If IRR < Cost of Capital, reject the project/negative NPV
Multiple IRR
If cash flows change between positive and negative, there can be more than one IRR.
Mutually Exclusive Projects:
A higher IRR doesn’t always mean a better project.
Borrowing Projects:
The IRR rule is reversed if a project starts with cash inflows instead of outflows.
Pros for IRR
-Relative measure, useful complement to NPV
-Considers the time value of money, shows return over whole life of the project
Cons for IRR
1.Can be multiple IRRs if cash flows change direction over life of project.
2. Higher IRR can give the incorrect impression that NPV is higher for that project across all discount
rates.
3. IRR maths assumes that cash generated by the project is immediately reinvested, generating a
return the same as this project. This can be unrealistic and can overstate return.
4. Likely to be misunderstood by non-expert
Capital rationing:
efers to a shortage of funds available
for investment projects
Soft capital rationing
internal restrictions on funds
for investment imposed by top management
Hard capital rationing:
due to an actual shortage of
funds available for investment
Profitability index:
: ensures the best ‘bang for the
buck’ when investing.
Profitability index measures in whar
Measures NPV per $ invested
Profitability index(PI) formula
𝑃𝐼 = NPV PROJECT/ INITAL INVESTMENT
what does PI >0 indicate
indicates the project is worthwhile
