Net Present value and other investment rules Flashcards
What is a project that is worth investing in?
If it creates value for the firm’s owners
What is the NPV rule?
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
What are the benefits of using a discounted cash flow model?
Fully incorporates the time value of money
What are the strengths of the NPV rule?
Uses all cash flows
Discounts cash flows
What is the payback period?
Payback period is the amount of time required for an investment to generate cash flows sufficient to recover as initial cost
When is an investment regarding payback acceptable?
An investment is acceptable if its calculated payback period is less than some pre-specified number of years
What is the payback rule applicable to?
- Very small-scale investments
- Firms with severe capital rationing
What are the short-comings of the payback rule?
- 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
What is the discounted payback period?
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)
When is an investment acceptable?
An investment is acceptable if its discounted payback is less than some pre-specified number of years
What is the average accounting return?
The average project earnings after taxes and depreciation divided by the average book value of the investment during it’s life
When does the average accounting return decide whether an investment is undertaken?
A project is acceptable if its average accounting return exceeds a target average accounting return
What are the short-comings of the AAR?
- 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
What is the IRR also known as?
Also known as the discount rate
What is the internal rate of return (IRR)?
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
What does a higher IRR mean?
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
When is an investment acceptable?
An investment is acceptable if the IRR exceeds the required return and rejected otherwise
What is the NPV profile?
A graphical representation of the relationship between an investment NPVs and various discount rates. IRR is where the curve intersects the y-axis
What are the shortcomings of the profitability index?
May lead to incorrect decisions in comparison of mutually exclusive investments
What are the advantages of the profitability index?
It is useful in the case of capital rationing and more generally limited resources
Why is it important to remember that capital is scarce?
Because investing in one project might lead to cutting a budget for others
What are incremental cash flows?
Any changes in the firm’s future cash flows that are a direct consequence of taking the project
What is a relevant cash flow?
Cash flows from the project, any cash flow that exists regardless of whether or not a project is undertaken is not relevant
What are sunk costs?
- Cash flows that have already occurred therefore should be ignored
What are opportunity costs?
- Lost revenues that you forgo because of making the proposed investment, incorporate
What is straight-line depreciation?
The asset’s cost (less any expected salvage value) is divided equally over it’s useful life
What are the side-effects and should they be included in our analysis?
Erosion and synergy. They should be included in side effects analysis
What is erosion?
When a new product reduces the cash flows of existing products
What is synergy?
Occurs when a new project increases the cash flows of exist in projects
What is allocated cost?
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.
How should interest payments be assessed in the DCF?
Interest paid or financial costs in general are NOT a relevant cash flow for incremental cash flow calculations
What is operating cash flow?
A measure of how much cash flow a business has generated without taking secondary sources of revenue such as interest into account
What is the time value of money?
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
