NPV and other investment criteria Flashcards
Who makes the investment decisions of a firm
Financial manager makes capital budgeting decisions
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
Define net present value
Present value of cash flows minus initial investments. its difference between market value pr investment and cost of investment
According to the NPV when is a project accepted or rejected
NPV >0 - accepted
NPV <0 - rejected
Define DCF valuation
Valuing investment by discounting its cash flows
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
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
What does mutually exclusive projects mean?
There are two or more projects to pick between because there are not enough resources to do both
What formula can be used in the NPV formula to shorten calculating PV of cash flows
annuity formula
When is project acceptable based on the AAR rule
Project is acceptable if it exceeds a target AAR
What are the advantages of the AAR method of investment analysis
Easy to use and information is readily available
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
Define payback
Length of time project takes to recover the initial investment
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
What does payback rule measure - not really questioning value of project
Measure of accounting breakeven but not economic (no time value of money)
Why is payback rule used so much?
Used to make minor decisions as its quick and simple
What are the advantages of the payback rule
Easy
Adjusts for uncertainty of later cash flows
Biased toward liquidity
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
