Marketing and Finance Flashcards
Net Profit and Return on Sales purpose
Measures fundamental profitability of business
Return on sales
- % of sales revenue that gets “returned” to the company as net profits
- Does not account for capital investment used
- Used to compare profitability of companies
Return on Investment (ROI) purpose
- Understand the profitability of single period investments
Problems with ROI
- Only single period
- Averaging profits and investments over periods can disguise profits and assets
- No consideration for opportunity cost and risk
Multi period investments
evaluation of investments that produce returns over multiple periods needs to consider both the magnitude and timing of the returns. Metrics need to deal with economic consequences occurring at different points in time.
Multi period investment metrics
Net present value
Internal rate of return
Payback
Time value of money
money available at the present time is worth more than the same amount in the future due to its potential earning capacity.
Cash flow
net amount of cash & cash-equivalents moving into & out of a business.
- Investments, paying debts, expenses are cash outflows
- Earnings are cash inflows
- Positive cash flow indicates that a company’s liquid assets (asset that can be converted into cash quickly) are increasing, while negative cash flow indicates that a company’s liquid assets are decreasing.
Discount rates/ interest rates
- The discount rate is the rate of return used in a discounted cash flow analysis to determine the present value (PV) of future cash flows.
- Investors use discount rates to translate the value of future investment returns into today’s dollars.
- Critical component of the time value of money.
- In terms of net present value calculation, concept is interchangeably used with interest rates; Hurdle rate; Required rate of return; Cost of capital; etc.
Present value
describes how much a future sum of money is worth today.
Net Present Value (NPV) purpose
to evaluate multi-period investments taking into account the time value of money and the risk involved
Net Present Value (NPV)
the difference between the present value of cash inflows and the present value of cash outflows that occur as a result of undertaking an investment project. It may be positive, zero or negative.
If Present value of cash inflow > present value of cash outflow
NPV is positive and the project is acceptable
If Present value of cash inflow = present value of cash outflow
NPV is zero and the project is acceptable
If Present value of cash inflow < present value of cash outflow
NPV is negative and project is not acceptable
What do NPV calculations reflect?
the time value of money by “discounting” (i.e. reducing) the value of future cash flows. In effect, cash flows received earlier in an investment project are considered to be worth more than those who are expected several years ahead.
What percentage (or “rate”) should be used to discount future cash flows?
- Consider using the interest rate which could be obtained on saving.
- A more common approach is to consider what the required rate of return is for shareholders - this takes into account the risk they perceive when investing in the business.
- Typically, the discount rate is decided at the corporate level.
NPV Problems
Reliability of future cash flow projections
What should be the basis of the discount rate used?
Cost of capital? Adjusted for risk?
Opportunity cost (investment alternatives with similar risk)?
Hurdle rate, target rate of return?
Present value or profitability index
Choosing among several alternative investment proposals:
• Sometime a company may have limited funds but several alternative proposals. In such circumstances, if each alternative requires the same amount of investment, the one with the highest net present value is preferred.
• But if each proposal requires a different amount of investment, then proposals are ranked using an index calledpresent value index (orprofitability index). The proposal with the highest present value index is considered the best.
Internal Rate of Return
- The discount rate for which the net present value of the investment is zero
- IRR uses the initial cost of the project and estimates of the future cash flows to figure out the interest rate.
- IRR should be higher than the cost of funds.
- IRR requires you to find a rate instead of a value.
Difference between IRR and NPV
- Both are discounted cash flow techniques for evaluating investments over multiple periods
- NPV formula solves for the present value of a stream of cash flows, given a discount rate. IRR on the other hand, solves for a rate of return when setting the NPV equal to zero (0).
IRR Construction considerations
- Using the NPV method, you can figure out internal rate of return through trial and error — plug different interest rates into your formulas until you figure out which interest rate delivers an NPV closest to zero
- In general, companies should accept projects with IRR that exceeds the cost of capital and reject projects that don’t meet that guideline. This can be compared to the company’s “hurdle rate” (a rate under which they would not undertake a project).
- Decision rule: If IRR is above the hurdle rate–> proceed with project, if IRR is below hurdle rate –> do not proceed
IRR Calculation
- The manual calculation of IRR using present value tables is challenging. One would repeatedly try rates until the rate that caused the present value of cash inflows to equal the present value of cash outflows is isolated.
- Computing internal rate of return may require estimating the NPV for several different interest rates and judging which rate results in the lowest NPV.
- Excel offers powerful functions for computing internal return of return, as do many financial calculators.
IRR Challenges
- Multiple solutions and the difficulty of solving n-factor equations
- With some cash flows, IRR is positive (despite negative cashflows)
- IRR sometimes ignores the magnitude of the project
