Topic 4- Investment Decision Rules Flashcards
What is the formula for book/accounting rate of return?
Book rate of return = Book income/Book assets
What is payback period?
Number of years before cumulative cash flow equals initial investment
What is the payback rule?
Only accept projects that pay back within desired time frame
What is the formula for payback period?
Payback period = no. of years full recovery + uncovered cost/cash flow in last year before payback
What does the payback rule not take into account?
It ignores the time value of money
What is the NPV rule?
Managers only accept projects with a positive NPV
What are mutually exclusive projects?
Taking one investment makes the other one redundant because they both serve the same purpose
How do you choose between mutually exclusive projects?
Calculate each project’s NPV and choose the one with the highest NPV
What is Internal Rate of Return (IRR)?
The discount rate that makes the project’s NPV = 0
What is the formula for IRR?
0 = C_0 + C_1/(1+IRR) +…+ C_t/(1+IRR)^t
What is the IRR rule?
Managers increase shareholders wealth by accepting all projects which offer an internal rate of return that is higher than the opportunity cost of capital (hurdle rate)
What is the opportunity cost of capital?
Expected rate of return (of second-best investment alternative) given up by investing in a project
When do NPV and IRR yield consistent results?
For independent investments
Give 4 cases when NPV and IRR can yield different choices
- Borrowing vs lending
- Multiple IRR
- Mutually exclusive projects: investments of different scale
- Mutually exclusive projects: timing of cash flows
Describe borrowing vs lending
Two projects may seem the same with identical IRRs but have different NPVs. Borrowing project accepted if IRR
When may there be multiple IRRs?
If cash flow changes sign during project
What is the formula for Profitability Index (PI)?
PI = NPV/Initial investment
How do you choose between projects with capital constraints?
Rank them by PI and try to use up your money in projects with highest PI. To break any ties, choose the one with the highest NPV
How can the reinvestment rate problem be solved?
By using the modified internal of return, assuming project’s CF’s can be reinvested at discount rate r
What is the use of PI?
It’s an alternative to NPV/IRR so to make projects of different scales comparable we need a relative measure
