Lent Term - Lecture 8

Question 1

What leverage should you use in computing the WACC and why?

Answer 1

Use the target leverage. Over the long run the firm should be closer to the target leverage.

Question 2

What is the IRR?

Answer 2

This is the rate that makes the NPV zero. Usually compared to a hurdle rate

Question 3

What are some drawbacks of IRR?

Answer 3

• Doesn’t take small into account
• There can be multiple IRRs (in cashes where the sign of cash flows changes frequently)
• There can be no IRR (with negative cash flows)

Question 4

How do we calculate the profitability index?

Answer 4

Divide the PV of future cash flows by the cost

Question 5

What is the advantage and disadvantage of profitability index?

Answer 5

Advantage - Gives information about the use of capital

Disadvantage - Prefers projects with lower upfront cost even if they have lower NPV

Question 6

Why is the payback rule a bad idea?

Answer 6

Has no sense of scale. Projects are not necessarily better just because you get the investment back faster.