Session 3: Project Appraisal Flashcards
What is the payback period, and how is it used in investment decisions?
The payback period measures how quickly an investment recovers its initial cost through cumulative cash inflows.
Acceptance Criterion: Management sets a maximum acceptable PBP (e.g., 3.5 years). If the calculated PBP is less than this threshold, the project is accepted.
What is the general formula for calculating the payback period?
What are the strengths of the payback period method?
- Simple and easy to understand
- Measures liquidity (how quickly investment is recovered)
- Useful for short-term forecasting
What are the weaknesses of the payback period method?
- Ignores the time value of money (does not consider discounted cash flows)
- Does not consider cash flows after the payback period
- Cutoff period is subjective and may lead to rejecting profitable projects
What is compounding in finance, and how does it affect future value?
- Compounding refers to the process where interest is added to the principal amount, and future interest is earned on both the initial principal and accumulated interest.
- The more frequently interest is compounded, the higher the future value, but at a diminishing rate.
What is the Effective Interest Rate (EIR), and why is it important?
The Effective Interest Rate (EIR) represents the true annual return on an investment or the actual cost of a loan after considering compounding effects. It is higher than the nominal interest rate when compounding occurs more than once per year.
Importance of EIR:
- Helps compare financial products with different compounding frequencies.
- Reflects the true cost of borrowing or actual return on investments.
- Shows how frequent compounding increases returns/costs over time.
What is the difference between the nominal interest rate and the effective interest rate (EIR)?
- Nominal Interest Rate: The stated annual interest rate, without considering compounding.
- Effective Interest Rate (EIR): The actual interest rate earned or paid after considering compounding effects.
EIR is always higher than the nominal rate if compounding occurs more than once per year.
What is discounting, and how is the present value (PV) calculated?
Discounting is the process of determining the value of a future cash flow in today’s terms by applying a discount rate. It is the reverse of compounding.
The higher the discount rate, the lower the present value of future cash flows.
What is the opportunity cost of capital, and how does it relate to the discount rate?
The opportunity cost of capital is the expected rate of return that investors demand for an investment project.
- It reflects the return investors would expect from an alternative investment with similar risk.
- It serves as the discount rate (or hurdle rate) used to evaluate projects.
- When future cash flows are discounted at this rate, the resulting value represents the maximum amount investors are willing to pay for the project.
How does Net Present Value (NPV) help in investment decisions?
Net Present Value (NPV) is the sum of all discounted future cash flows minus the initial investment cost.
- If NPV > 0, the project increases shareholder value and should be accepted.
- If NPV < 0, the project destroys value and should be rejected.
A positive NPV means the project is expected to generate returns above the required rate, making it a worthwhile investment.
What is Net Present Value (NPV), and how do you interpret it?
Net Present Value (NPV) measures the value an investment adds to a company by discounting future cash flows to present value and subtracting the initial investment.
Interpretation:
- NPV > 0 → The project earns more than its cost and should be accepted.
- NPV = 0 → The project earns exactly the required return (break-even).
- NPV < 0 → The project earns less than the required return and should be rejected.
A positive NPV indicates an increase in shareholder value.
What is the Internal Rate of Return (IRR), and how does it relate to investment decisions?
The Internal Rate of Return (IRR) is the discount rate that makes the NPV of a project equal to zero. It represents the break-even rate of return for an investment.
Investment Decision Rules:
- NPV Rule: Accept projects with positive NPV (adds value to the firm).
- IRR Rule: Accept projects where IRR > cost of capital (provides higher returns than alternatives).
- Same Decision Outcome: NPV and IRR usually lead to the same decision, but NPV is preferred for accuracy.
If the IRR is higher than the required return, the project is a good investment.
What is a perpetuity, and how is its present value calculated?
A perpetuity is a financial instrument that provides infinite cash flows, often used for valuing preferred stocks, endowments, or infinite investments.
- Perpetuities do not have a maturity date, meaning the cash flows continue indefinitely.
What is a growing perpetuity, and how is its present value calculated?
Growing perpetuity is a perpetuity where cash flows grow at a constant rate (g) each year.
This formula is used for valuing companies with stable long-term growth.
How does discounted cash flow (DCF) valuation determine company value?
The discounted cash flow (DCF) method values a company based on the present value of its expected future earnings.
- Company Value = Capitalized Value of Future Earnings
- Future cash flows are uncertain, so they are discounted to reflect their value today.
- Used to estimate the intrinsic value of firms or assets.
Key Elements in DCF Valuation:
- Cash Flow (CF): What type? How to estimate?
- Terminal Value (TV): Value beyond the forecast period.
- Discount Rate (r): Typically derived from the Weighted Average Cost of Capital (WACC).
- Planning Period (n): How long should projections last?
Since the future is uncertain, there is a lot of room for interpretation
There are many discounted cash flow models in existence ⇒ minor differences
What is the Internal Rate of Return (IRR) and how is it estimated?
The Internal Rate of Return (IRR) is the discount rate that makes the Net Present Value (NPV) of a project equal to zero.
It represents the project’s break-even rate of return.
Method for Estimating IRR:
Decision Rule: Accept a project if IRR ≥ required return (hurdle rate).
What is the formula for estimating the Internal Rate of Return (IRR)?
This method estimates IRR by testing discount rates and interpolating between them.
What are the strengths and weaknesses of the Internal Rate of Return (IRR) method?
Strengths of IRR:
- Accounts for the time value of money.
- Considers all cash flows over the project’s life.
- Less subjectivity compared to other methods.
Weaknesses of IRR:
- Difficulties with project ranking when comparing multiple projects.
- Multiple IRRs can exist in non-standard cash flow patterns.
- Assumes that all cash flows are reinvested at the IRR rate, which may not always be realistic.
Despite its drawbacks, IRR is widely used alongside NPV in investment decision-making.
What is the formula for the Profitability Index (PI) and its decision rule?
The Profitability Index (PI) measures the ratio of the present value of a project’s future cash flows to its initial investment.
Decision Rule:
Accept if PI ≥ 1.00 → The project is profitable and creates value.
Reject if PI < 1.00 → The project destroys value and should not be undertaken.
What are the strengths and weaknesses of the Profitability Index (PI)?
Strengths:
- Similar to NPV, as both use discounted cash flows.
- Allows comparison of projects with different scales (useful when investment amounts vary).
Weaknesses:
- Same limitations as NPV, such as reliance on cash flow estimates and discount rate assumptions.
- Provides only relative profitability, not absolute profit (unlike NPV, which gives a dollar amount).
What is Economic Value Added (EVA), and what does it measure?
- EVA is a way to determine the value created above the required return in a euro amount
It Measures profit less the cost of capital employed:
EVA = (Rate of Return - Cost of Capital) x Capital
Sometime the Terms are named differently:
- Rate of Return: ROCE or ROIC
- Cost of Capital: WACC
What is the expanded formula for EVA, and what do its components mean?
EVA = NOPAT − (WACC × NOA)
Where:
- NOPAT = Net Operating Profit After Tax (sometimes called NOPLAT: adjusted for taxes).
- WACC = Weighted Average Cost of Capital, representing the minimum required return.
- NOA = Net Operating Assets, the capital employed in operations.
Rule:
- If EVA > 0, the company is creating value.
- If EVA < 0, the company is destroying value.
How does EVA differ from NPV, and why do companies use it?
- NPV (Net Present Value): Forward-looking, used for investment decisions.
- EVA: Backward-looking, measures past performance and managerial effectiveness.
- Helps assess if a company earns more than its cost of capital.
- Used for performance evaluation and financial decision-making.
- Trademark of Stern Stewart & Co.
