Module 6 - Applications of Company Investment Analysis Flashcards
Problems with the payback period include?
- It ignores all cash flows beyond the maximum acceptable payback period.
- It does not discount the cash flows within the maximum acceptable period, thereby giving equal weight to all of them. This is inconsistent with shareholder opportunity costs.
What is the discounted payback period procedure?
Some companies have altered their payback period techniques to be discounted payback periods. This procedure calculates the present values of cash flows, and dictates a minimum acceptable period until the discounted cash flows accumulate to equal the initial outlay.
- This payback is generally only accurate for projects with …
…fairly consistent cash flows each period.
Payback is not generally a preferred technique because it ignores the discounting process and the cash flows beyond the payback point. But under a few limited instances (constant cash flows and equal-risk projects, for
example), a company could design a payback criterion that produced correct answers.
The average (accounting) return on investment (AROI) calculates a rate of return on the investment…
… in each period by dividing expected accounting profits by the net book value of the investments assets.
Example 6/4
The AROI does have some value as an…
… evaluation of control device to check the progress of an ongoing project on a period-by-period basis.
Most of the time, when the decision to be made is simply whether or not a particular project should be accepted (so that the choice does not involve finding the best among a set of competing projects), IRR gives the correct answers.
There is, however, one exception to this rule?
When there is an outlay, an inflow, and another outlay (in the form of an opportunity cost), multiple IRRs can exist – Sign changes across time can yield multiple IRRs.
As long as the IRR is greater than the hurdle rate (discount rate to find NPV), the NPV…
…will be positive.
We accept projects when the NPV is positive, or when the IRR is greater than it’s hurdle rate.
In situations where multiple investment options must be compared and subsequently ranked the…
…NPV technique is best.
When IRR must be used the incremental cash flow analysis technique should be used. The steps are:
- Take any two projects out of the group.
- Find the one that has the highest net positive cash flow total (sum of all FCF*s). The investment with the highest net cash flow is the defender, the other the challenger.
- At each time point, subtract the cash flows of the challenger from those of the defender, the resulting stream are the incremental cash flows.
- Find the IRR of the incremental cash flows.
- If the IRR is greater than the appropriate hurdle rate, keep the defender and throw out the challenger and visa versa.
- Pick the next project out of the group and repeat the process using the winner of step 5 until only one investment remains.
- Calculate the IRR of the winner. If it is greater than the hurdle rate, accept it, if not then reject all the projects.
This algorithm works because it looks at the IRR of choosing one project over another, instead of comparing investments’ IRRs.
There are also situations in which the incremental cash flow method of choosing among investments should never be used:
- When the incremental cash flows have more than one change of sign across time.
- When the projects differ in risk or financing, so that they require different hurdle rates
The IRR and NPV will usually give the same indication of investment desirability if the question is simply whether or not to accept a particular project. The IRR, however, will not generally give correct rankings of several alternative (mutually exclusive) projects. When such decisions must be analysed with IRR, the…
…incremental rate algorithm should be used.
The IRR is unlikely to be useful if…
… each cash flow must be considered as having a unique discount rate.
- The cost–benefit ratio (CBR) is defined as…
… the ratio between the present value of the cash inflows and the cash outflows of an investment:
An investment is accepted if CBR is >1, and rejected is CBR is <1.
If NPV is available, it should be used over CBR.
The cost–benefit ratio does in fact have almost the same drawbacks as the IRR in choosing among investment alternatives, because a ratio suffers the same limitations as a rate of return when comparisons as to wealth implications are required.
Define PI
- A PI > 1 signals an acceptable investment.
- The PI is only used when the present cash flow (<var>FCF</var>*0) is a net outlay.
- The PI is the ratio of the accumulated present values of future cash flows to the present cash flow of an investment.
- The PI is a ratio measure and therefore suffers from the same problems of CBR.
- PI is unsuitable for ranking investments because it displays another relative measure, the wealth increase per pound of initial outlay instead of the wealth increase itself.
The cost–benefit ratio does in fact have almost the same drawbacks as the IRR in choosing among investment alternatives, because a ratio suffers the same limitations as a rate of return when comparisons as to wealth implications are required.
Definition of Capital Rationing
The set of methods used to choose a group of projects that will maximise shareholder wealth while having limited funds available is called capital rationing techniques.
Definition of exhaustive enumeration
When having to choose between a few projects, one simply looks at all the possible combinations of investments that lie within the budget and choose the package with the greatest NPV. This is called exhaustive enumeration.
Method to choose project…
When confronted with many projects to choose from, one common method is to calculate the profitability indices for the investments, and to list them in declining order of PI. Investments are then accepted in order of PI, until the budget has been exhausted.
The PI technique must be used with some caution in ranking investments when the highest PI projects do not use up the entire budget
The capital rationing situation implies…
…that financing beyond the budget constraint carries not a high but an infinite cost
Explain
- Pure contingency: the cash flows of a particular project cannot exist unless those associated with another investment are accepted
- Mutual exclusivity: the acceptance of a particular alternative implies the rejection of the cash flows of all that are mutually exclusive of it
- Economic independence implies that the acceptance or rejection of one project has no effect upon the cash flows of the projects with which it is economically independent
When a company faces a decision between renewable assets that are of different lifetimes, the equivalent annual cost technique is used. Explain:
- The NPV of a single lifetime or cycle for each asset is found.
- Divide each NPV by the annuity present value factor for the number of years in each asset’s replacement cycle at the appropriate discount rate.
- The result is the constant annuity outlay per period that has the same NPV as the asset.
- Compare the per-period equivalent annuity outlay for each asset and choose that which the lower cost per period
Deine Nominal Price
A `Nominal´ price is the actual number of £s (or whatever currency) that would change hands at the time the purchase is made.
Define Real Price
A `Real price´ is the number of £s (or whatever currency) that would have been exchanged to purchase something before the inflation took place
