NPV and other investment criteria Flashcards by Sarah Oliver

Who makes the investment decisions of a firm

Financial manager makes capital budgeting decisions

How well did you know this?

Not at all

Perfectly

Define opportunity cost of capital

Required rate of return - expected rate of return given up by investing in a project. Should be greater than/equal to interest one can always earn

How well did you know this?

Not at all

Perfectly

Define net present value

Present value of cash flows minus initial investments. its difference between market value pr investment and cost of investment

How well did you know this?

Not at all

Perfectly

According to the NPV when is a project accepted or rejected

NPV >0 - accepted

NPV <0 - rejected

How well did you know this?

Not at all

Perfectly

Define DCF valuation

Valuing investment by discounting its cash flows

How well did you know this?

Not at all

Perfectly

Why is NPV>0 good for shareholders

Market value> cost means investment creates value for owners which is the goal of financial management maximising shareholder equity value

How well did you know this?

Not at all

Perfectly

Steps to find the NPV

Estimate opportunity cost of cash flow and expected future cash flow
Estimate PV of cash flows at discount rate
Compare NPV from any mutually exclusive investments - big one with highest NPV

How well did you know this?

Not at all

Perfectly

What does mutually exclusive projects mean?

There are two or more projects to pick between because there are not enough resources to do both

How well did you know this?

Not at all

Perfectly

What formula can be used in the NPV formula to shorten calculating PV of cash flows

annuity formula

How well did you know this?

Not at all

Perfectly

When is project acceptable based on the AAR rule

Project is acceptable if it exceeds a target AAR

How well did you know this?

Not at all

Perfectly

What are the advantages of the AAR method of investment analysis

Easy to use and information is readily available

How well did you know this?

Not at all

Perfectly

What were the disadvantages of the AAR method of investment analysis

No true rate of return with no considering time value of money
Arbitrary benchmark cut off rate
Accounting (book) values are not cash flow/ market values

How well did you know this?

Not at all

Perfectly

Define payback

Length of time project takes to recover the initial investment

How well did you know this?

Not at all

Perfectly

When is a project accepted or rejected based on payback rule/ discounted payback rule

Accepted if calculated payback period is less than some required period of time (pre set by firms)
Rejected is more than that

How well did you know this?

Not at all

Perfectly

What does payback rule measure - not really questioning value of project

Measure of accounting breakeven but not economic (no time value of money)

How well did you know this?

Not at all

Perfectly

Why is payback rule used so much?

Used to make minor decisions as its quick and simple

How well did you know this?

Not at all

Perfectly

What are the advantages of the payback rule

Easy
Adjusts for uncertainty of later cash flows
Biased toward liquidity

How well did you know this?

Not at all

Perfectly

What are the disadvantages of the payback rule

Ignores time value of money
Requires arbitrary cut off point - no basis for estimate
Ignores cashflow after that point
Biased against long term projects - ex: R&D
Can result in multiple payback periods with minus cashflows not at the beginning
Doesn’t consider risk differences

Define the discounted payback rule

Length of time required for an investments discounted cash inflows to equal or exceed initial cost of investment - considers time value of money
Investment accepted if payback is less than pre specified time

What is discounted payback rule measuring?

Measure of breakeven in economic and financial sense

Advantages of discounted payback rule

Easy
Does not accept negative estimated NPV investments
Includes time value of money
Biased towards liquidity

Disadvantages of discounted payback rule

Can reject positive NPV investments
Requires arbitrary cut off point - no basis for estimate
Ignores cashflow after that point
Biased against long term projects - ex: R&D

What does IRR stand for

Internal rate of return

Define IRR

Discount rate that will equate PV of expected cash outflows to the PV of expected cash inflows (so NPV = 0)

Based on analysis of the IRR when is investment accepted or rejected

IRR > Opportunity cost of capital (rate of return) the accept investment

Define NPV profile

Graphical representation of relationship between an investments NPVs and various discount rates

How do I calculate the IRR for stand alone projects

If you dont have discount rate or cost of capital use trial and error, excel

How does correlation between NPV and IRR change for non conventional projects with different cash flow patterns

If cash flow changes sign ex: for insurance/ pension firm postiive cash flow is followed by all negative future cash flow the multiple IRR will happen and IRR rule does nothing as often computer only picks up on first IRR. You can use NPV rule to say that if Return is between a certain range then project is accepted

How does correlation between NPV and IRR change for mutually exclusive projects.

Problem as IRR ignores the scale of investment as rate of return is a % ignoring size. May give higher IRR on smaller investment compare to larger size investment - Could reject projects with higher NPVs

Discuss the timings of cash flows and how this relates to the IRR and the NPV

Project with larger cash flows at later stage - lower IRR than project with larger cash flow earlier Opposite for NPV of the project

Define crossover rate

Discount rate as which the NPVs of two mutually exclusive project investments are equal

what is IRR trap for lending/borrowing

Same in both cases - always remember is IRR is high and you are borrowing this is bad!

Advantages of IRR

Related to NPV - leads to identical decisions for stand alone conventional work Easy to understand and communicate Easy to estimate even without return cut off

Disadvantages of IRR

Can result in multiple answers - non conventional cash flows | May lead to incorrect decisions - mutually exclusive investments

Why is IRR popular

Financial analysist prefer talking rate of return over cash values

Define MIRR

Modified IRR is rate of return on modified set of cash flows aiming to solve problem of IRR with nonconventional cash flows

What are the three approaches to MIRR

Discounting Reinvestment Combination

Define the discounting approach to MIRR

Discounts all negative cash flows back to present at the required return and adds them to initial cost before calculating IRR

Define the reinvesting approach to MIRR

Compound all cash flows except the first out to the end of the projects life and calculate IRR then

Define the combination approach to MIRR

Means negative cash flows are discounted back to present and positive ones are compounded to end of project before calculating IRR

What is another name for profitability index

Benefit to cost ratio

By the PI method when is project accepted or rejected

If PI > 1 NPV > 0 so accept | If PI < 1 NPV <0 so reject

What are the advantages of PI

Closely related to NPV - often same decision Easy to understand and communicate Useful when investment funds are limited - choose highest PI

What are the disadvantages of PI

May lead to incorrect decisions in comparisons of mutually exclusive investments