LT decision making

Question 1

Payback

+ve and -ve

Answer 1

Time taken for cash flows of project to pay back initial investment.
Accept projects with pp < required pp

+ve are quick, widely used, considers liquidity (cash flows), easily understood

-ve are max period is arbitrary, ignores the timing of cash flows, not take into account inflation - time value of money, doesn’t take into account all cash flows associated and how generated

Question 2

NPV

Answer 2

Net present value
The bet total of the discounted cash flows of the project.

Difference between: sum of discounted cash flows expected from investment and the initial amount invested

Question 3

Purpose of NPV

Answer 3

Max amount investor would be willing to pay for a given set of future cash flows, given the investors cost of capital. (Takes into account the time value of money)

Question 4

Decision rule

Answer 4

If NPV > 0 then accept!

If between two then project with highest NPV

NPV most important factor is assessing projects

Question 5

NPV -ve +ve

Answer 5

-ve are tricky concept, not allow for risk of project, difficult to identify an appropriate discount rate

+ve are accounts for time value of money, based on cash flows which are less subjective than profit, consistent with maxing shareholders wealth (benefit with NPV >O)

Question 6

IRR

Answer 6

Internal rate of return

Discount rate that gives NPV of 0. It can also be defined as the percentage return from an investment

Question 7

IRR +ve and -ve

Answer 7

+ve are simple % easily understood, not require exact cost of capital, time value of money, indicates how sensitive Cals are to changes in interest rates

-ve are canny accommodate changing interest rates, sometimes rank projects incorrectly, complex to cal