Net Present value and other investment rules

Question 1

What is a project that is worth investing in?

Answer 1

If it creates value for the firm’s owners

Question 2

What is the NPV rule?

Answer 2

We use the discounted cash flow valuation to calculate NPV. An investment should be accepted if the NPV is positive and rejected if it is negative

Question 3

What are the benefits of using a discounted cash flow model?

Answer 3

Fully incorporates the time value of money

Question 4

What are the strengths of the NPV rule?

Answer 4

Uses all cash flows
Discounts cash flows

Question 5

What is the payback period?

Answer 5

Payback period is the amount of time required for an investment to generate cash flows sufficient to recover as initial cost

Question 6

When is an investment regarding payback acceptable?

Answer 6

An investment is acceptable if its calculated payback period is less than some pre-specified number of years

Question 7

What is the payback rule applicable to?

Answer 7

• Very small-scale investments
• Firms with severe capital rationing

Question 8

What are the short-comings of the payback rule?

Answer 8

• It ignores the time value of money
• Ignore risks: very risky and very safe projects are calculated in the same way
• The pre-defined cut-off period is arbitrarily chosen which is misleading

Question 9

What is the discounted payback period?

Answer 9

The length of time required for an investment’s discounted cash flows to equal its initial cost (the time it takes to break even in an economic or financial sense)

Question 10

When is an investment acceptable?

Answer 10

An investment is acceptable if its discounted payback is less than some pre-specified number of years

Question 11

What is the average accounting return?

Answer 11

The average project earnings after taxes and depreciation divided by the average book value of the investment during it’s life

Question 12

When does the average accounting return decide whether an investment is undertaken?

Answer 12

A project is acceptable if its average accounting return exceeds a target average accounting return

Question 13

What are the short-comings of the AAR?

Answer 13

• Not a true rate of return; ignores the time value of money
• It’s an arbitrary benchmark
• Based on accounting (book) values, not cash flows and market values

Question 14

What is the IRR also known as?

Answer 14

Also known as the discount rate

Question 15

What is the internal rate of return (IRR)?

Answer 15

IRR is discount rate that makes the NPV of an investment zero. Or the interest rate that will bring a series of cash flows to a net present value of zero or the current value of cash invested

Question 16

What does a higher IRR mean?

Answer 16

The higher the projected IRR on a project, the higher the net cash flows to the company as long as the IRR exceeds the cost of capital a company would be well off to proceed with the project or investment. If the IRR is lower than the cost of capital, the best course of action is to forego the project

Question 17

When is an investment acceptable?

Answer 17

An investment is acceptable if the IRR exceeds the required return and rejected otherwise

Question 18

What is the NPV profile?

Answer 18

A graphical representation of the relationship between an investment NPVs and various discount rates. IRR is where the curve intersects the y-axis

Question 19

What are the shortcomings of the profitability index?

Answer 19

May lead to incorrect decisions in comparison of mutually exclusive investments

Question 20

What are the advantages of the profitability index?

Answer 20

It is useful in the case of capital rationing and more generally limited resources

Question 21

Why is it important to remember that capital is scarce?

Answer 21

Because investing in one project might lead to cutting a budget for others

Question 22

What are incremental cash flows?

Answer 22

Any changes in the firm’s future cash flows that are a direct consequence of taking the project

Question 23

What is a relevant cash flow?

Answer 23

Cash flows from the project, any cash flow that exists regardless of whether or not a project is undertaken is not relevant

Question 24

What are sunk costs?

Answer 24

• Cash flows that have already occurred therefore should be ignored

Question 25

What are opportunity costs?

Answer 25

• Lost revenues that you forgo because of making the proposed investment, incorporate

Question 26

What is straight-line depreciation?

Answer 26

The asset’s cost (less any expected salvage value) is divided equally over it’s useful life

Question 27

What are the side-effects and should they be included in our analysis?

Answer 27

Erosion and synergy. They should be included in side effects analysis

Question 28

What is erosion?

Answer 28

When a new product reduces the cash flows of existing products

Question 29

What is synergy?

Answer 29

Occurs when a new project increases the cash flows of exist in projects

Question 30

What is allocated cost?

Answer 30

An accounting measure to reflect expenditure or an assets use across the whole company.

Should be viewed as a cash outflow. Only if it is an incremental cost of the project.

Question 31

How should interest payments be assessed in the DCF?

Answer 31

Interest paid or financial costs in general are NOT a relevant cash flow for incremental cash flow calculations

Question 32

What is operating cash flow?

Answer 32

A measure of how much cash flow a business has generated without taking secondary sources of revenue such as interest into account

Question 33

What is the time value of money?

Answer 33

The time value of money (TVM) is the concept that a sum of money is worth more now than the same sum will be at a future date due to its earnings potential in the interim