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FIN20040 - Foundations of Finance > NPV and other investment criteria > Flashcards

NPV and other investment criteria Flashcards

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1
Q

Who makes the investment decisions of a firm

A

Financial manager makes capital budgeting decisions

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2
Q

Define opportunity cost of capital

A

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

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3
Q

Define net present value

A

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

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4
Q

According to the NPV when is a project accepted or rejected

A

NPV >0 - accepted

NPV <0 - rejected

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5
Q

Define DCF valuation

A

Valuing investment by discounting its cash flows

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6
Q

Why is NPV>0 good for shareholders

A

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

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7
Q

Steps to find the NPV

A
  1. Estimate opportunity cost of cash flow and expected future cash flow
  2. Estimate PV of cash flows at discount rate
  3. Compare NPV from any mutually exclusive investments - big one with highest NPV
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8
Q

What does mutually exclusive projects mean?

A

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

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9
Q

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

A

annuity formula

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10
Q

When is project acceptable based on the AAR rule

A

Project is acceptable if it exceeds a target AAR

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11
Q

What are the advantages of the AAR method of investment analysis

A

Easy to use and information is readily available

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12
Q

What were the disadvantages of the AAR method of investment analysis

A

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

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13
Q

Define payback

A

Length of time project takes to recover the initial investment

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14
Q

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

A

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

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15
Q

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

A

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

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16
Q

Why is payback rule used so much?

A

Used to make minor decisions as its quick and simple

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17
Q

What are the advantages of the payback rule

A

Easy
Adjusts for uncertainty of later cash flows
Biased toward liquidity

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18
Q

What are the disadvantages of the payback rule

A

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

19
Q

Define the discounted payback rule

A

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

20
Q

What is discounted payback rule measuring?

A

Measure of breakeven in economic and financial sense

21
Q

Advantages of discounted payback rule

A

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

22
Q

Disadvantages of discounted payback rule

A

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

23
Q

What does IRR stand for

A

Internal rate of return

24
Q

Define IRR

A

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

25
Q

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

A

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

26
Q

Define NPV profile

A

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

27
Q

How do I calculate the IRR for stand alone projects

A

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

28
Q

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

A

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

29
Q

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

A

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

30
Q

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

A

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

31
Q

Define crossover rate

A

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

32
Q

what is IRR trap for lending/borrowing

A

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

33
Q

Advantages of IRR

A

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

34
Q

Disadvantages of IRR

A

Can result in multiple answers - non conventional cash flows

May lead to incorrect decisions - mutually exclusive investments

35
Q

Why is IRR popular

A

Financial analysist prefer talking rate of return over cash values

36
Q

Define MIRR

A

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

37
Q

What are the three approaches to MIRR

A

Discounting
Reinvestment
Combination

38
Q

Define the discounting approach to MIRR

A

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

39
Q

Define the reinvesting approach to MIRR

A

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

40
Q

Define the combination approach to MIRR

A

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

41
Q

What is another name for profitability index

A

Benefit to cost ratio

42
Q

By the PI method when is project accepted or rejected

A

If PI > 1 NPV > 0 so accept

If PI < 1 NPV <0 so reject

43
Q

What are the advantages of PI

A

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

44
Q

What are the disadvantages of PI

A

May lead to incorrect decisions in comparisons of mutually exclusive investments

FIN20040 - Foundations of Finance (9 decks)

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