S8 - Investment criteria Flashcards
What is the average accounting return (AAR)? How do you interpret it? What are its advantages and disadvantages?
Definition and interpretation
- A ratio: some measure of average accounting profit divided by some measure of average accounting value.
- Many different definitions; in the book: Average net income/Average book value
- If AAR > target cutoff rate -> we accept the project
- Not meaningful economically and does not provide any information on the impact of an investment on the share price (not useful for a financial manager)
Advantages
- Simple; always possible to calculate it: accounting information is always available.
Disadvantages
- It is based on accounting values, not cash flows and not market value.
- Uses an arbitrary benchmark cutoff rate.
- Ignores time value of money. Not a true rate of return.
- Does not measure value creation.
What is the payback period (PP)? How do you interpret it? What are its advantages and disadvantages?
Definition and interpretation
- How long does it take to get the initial cost back?
- If PP < cutoff period -> we accept the project
- Mainly used when decisions involved a relatively small initial investment.
Advantages
- Simple and quick to calculate. Easy to understand.
- Favor short term projects (in favor of liquidity)
- Considers cash flows
Disadvantages
- Requires an arbitrary cutoff point.
- Ignores time value of money.
- Does not measure value creation.
- Subjective standards
- Ignores CF beyond the cutoff date… (after you get your money back)
- Doesn’t tell anything about the impact of a project on the firm value. The time required to recover the initial investment is not a relevant measure.
What is the net present value (NPV)? How do you interpret it? What are its advantages and disadvantages?
Definition and interpretation
- Sum of all future discounted cash flows generated by the project minus the initial investment.
- A positive NPV number will state how much value would be created or added today if the project is undertaken.
- If NPV > 0 -> we accept the project (when =, indifferent)
Advantages
- Considers CFS
- Considers time value of money (and risk through the discount rate)
- Objective
- Measures wealth creation in $
Disadvantages
- Could lead to poor choice in a situation where funds are limited
What is the profitability index (PI)? How do you interpret it? What are its advantages and disadvantages?
Definition and interpretation
- The index is defined as the sum of all future discounted CF generated by the project, divided by the initial investment.
- If PI >= 1 -> we accept the project
- If NPV >=0 -> PI >= 1 (closely linked)
Advantages
- Considers CF. Takes time value of money into account.
- Closely related to NPV, generally leading to identical decisions.
- Easy to understand and communicate. Objective.
Disadvantages
- Does not directly measure wealth creation in $ (as does the NPV).
- May lead to incorrect decisions in comparisons of mutually exclusive investment (if you accept project A you need to reject project B).
Sometimes, the PI doesn’t consider the intitial investment (lower PI B but A higher initial investment so more profitable)
What is the internal rate of return (IRR)? How do you interpret it?
Definition and interpretation
- The rate of return of a project
- The IRR is the return that makes the NPV = 0
- If IRR > required return -> accept the project
- NPV and IRR always lead to identical decisions as long as 2 very important conditions are met: project is independent (NOT mutually exclusive) and Project generates conventional CFs (when –+- CF, -> unconventional CF)
- High IRR don’t necessarily mean a positive NPV
In conclusion, what should you use? Why?
Best criteria: NPV because it measures the change in firm value in $ (and profitability index).
The discounted payback period time is a good ‘second’ criterion’.
IRR give a valuable intuition, but has a few major flaws.
