Profit Criteria Flashcards
1
Q
NPV Definition
A
Expected present value of future cashflows under a contract, discounted at the risk discount rate
2
Q
NPV Advantages
A
- Economic theory dictate s that investor chooses project with higher NPV
- Can compare projects of different sizes, timings, unequal lives
- Takes into account investment size – absolute amounts of wealth change
- Can handle non-conventional cashflows
- Additive
- Assumes cashflows generated during life of project can be reinvested at rate equal to opp cost of capital - reasonable
3
Q
NPV Disadvantages
A
- Assumes perfectly free and efficient capital markets
- Assumes discount rate correctly reflects inherent riskiness of product
- Not very simple to present to non-technical people
- By itself tells you very little – needs to be expressed in terms of a ratio to be more meaningful (eg in terms of pv of premium, dist cost/initial commission)
4
Q
IRR Definition
A
Discount rate that would give a NPV of 0
5
Q
IRR Advantages
A
- Simple
- Compatible with shareholders saying “we want a return of at least x%”
- No need to formulate discount rate
- Easily comparable with other forms of investment (?)
6
Q
IRR Disadvantages
A
- May not be unique
- May not exist
- Doesn’t take size of project into account when comparing alternatives
- Difficult to relate to other measures (eg premium income)
- Assumes cashflows generated during life of project can be reinvested at rate equal to IRR. As IRR increases this assumption becomes more unrealistic
- Doesn’t handle non-conventional cashflows well (multiple changes in sign of cashflow)
- Not additive
7
Q
DPP Def
A
Earliest policy duration at which the accumulated value of profits is 0
8
Q
DPP Advantages
A
- Useful means of comparing products if capital is a particular problem
- Easy to explain as a breakeven point
- Simple to calculate
- Useful screening device
9
Q
DPP Disadvantages
A
Often not agree with NPV – ignores cashflows subsequent to the DPP itself
