T2 Investment Decisions Flashcards
PV equation after one period
PV equation after multiple periods
Use discounted cash flow formula
Opportunity cost of capital
return foregone from a certain investment activity
NPV equation
NPV = PV - Cost of Investment
Qo - initial cost of investment
Qt - future costs
Decision rule for NPV
Accept investments that have a positive NPV
Consider the problem of buying a building to transform it into office space. Now assume:
-the building will be ready for sale at the end of 2 years from now;
-it is expected to fetch £200,000 with certainty.
-initial payment: £60,000; plus £20,000 at the end years 1 and 2.
-end year 2: costs of transforming it into office space (£50,000).
-Alternative investment opportunity (e.g. a bond) yields an annual rate of return of 5%.
CALCULATE NPV
Profitability Index (PI)
Ratio of NPV to cost of investment PI = NPV/Q
Pick project with highest NPV per £ of initial investment
Pitfalls - possible bias against costly projects although they may have larger NPV, cannot cope with mutually exclusive projects
Book rate of return
book income as a proportion of the book value of the assets the firm is acquiring
BRR = book income/book assets
Pitfalls - bias against more costly projects with higher NPV
Payback period
number of years it takes for cumulative cash flow from project to equal initial investment
Payback rule
project should be accepted if its payback period is less than some specific cut off period
Pitfalls - cash flows after cut off date are ignored
cash flows before cut off date treated equally without discounting
Internal rate of return
rate of discount that makes NPV = 0
IRR rule
If IRR > opportunity cost of capital r project should be undertaken.
Pitfall - in case of borrowing IRR rule works the other way round opportunity cost > IRR
May be multiple IRRs if project incurs future costs
how to find NPV using a graph
A
A
B & C
D
E
RoR rule
accept investments RoR > r
