P2E.2 Capital Investment Analysis Methods

Question 1

Discounting

Answer 1

Process of translating a future value into its present value.

How much do you need to invest today to generate a specified future cash flow within a specified period of time at a given rate of return?

Question 2

Compounding

Answer 2

Process of translating a present value into its future value.

How much will you receive on a specified future date if you invest a specified amount today at a given rate of return?

Question 3

Net Present Value (NPV)

Answer 3

1. Dollar amount of the difference between present value of cash inflows and present value of cash outflows.
2. Measures the discounted cash-basis profitability of the capital investment.
3. Represents the excess cash generated on the project once the initial outlay has been recouped.

NPV>0 Accept
NPV<0 Reject
NPV=0 Breakeven point

Question 4

Internal Rate of Return (IRR)

Answer 4

1. Rate at which the present value of cash inflows equals the present value of cash outflows.
2. Rate of return when the NPV equals 0.

IRR>RRR Accept
IRR<0 Reject
IRR=0 Breakeven point

Question 5

Components needed to evaluate potential capital investment

Answer 5

1. How much cash is needed initially for the investment?
2. How much cash flow is expected in the future from the investment (inflow & outflow)?
3. What is the required rate of return?

Question 6

Net Present Value (NPV) Advantages & Disadvantages

Answer 6

Advantages
1. Considers time value of money

Disadvantages
1. Doesn’t provide info in regards to length of time when investment hits breakeven point.

Question 7

Internal Rate of Return (IRR) Advantages & Disadvantages

Answer 7

Advantages

1. Accounts for time value of money
2. Provides info regarding efficiency of initial investment.

Disadvantages

1. May be multiple or no IRRs.
2. Essentially a plug to arrive at a NPV of 0.

Question 8

Conflicting rankings between NPV & IRR

Answer 8

NPV may show Project A is the better choice whereas IRR may show Project B is the better choice.

NPV should be used when conflicting rankings occur.

Question 9

Assumptions of NPV & IRR

Answer 9

1. Cash flows can be reinvested at a given rate
2. IRR may not be reasonable for actual return on CF.
3. Initial cash outflow occurs at beginning of year 1 and successive cash flow occurs at end of year.
4. Cash flows are certain and known.

Question 10

Breakeven Time

Answer 10

Time required to recover the cash invested in a project. However, since almost all investment projects span several years, it is necessary to discount both cash inflows and outflows. When this is done, breakeven time becomes “the point where discounted cumulative cash inflows on a project equal discounted total cash outflows.”

Question 11

Profitability Index

Answer 11

1. The profitability index assumes that there is capital rationing and that potential investment opportunities are mutually exclusive.
2. The profitability index approach to investment analysis always yields the same accept/reject decisions for independent projects as the net present value method.
3. Profitability index or excess present value index is the ratio of the present value of future net cash inflows to the discounted initial net investment.
   - PV of future net cash inflows ÷ Discounted initial net investment
   - This variation of the net present value method facilitates comparison of different-sized investments.
   Since the profitability index is a variation of the NPV method, the two methods will always rank investment choices in the same order.