Topic 4- Investment Decision Rules

Question 1

What is the formula for book/accounting rate of return?

Answer 1

Book rate of return = Book income/Book assets

Question 2

What is payback period?

Answer 2

Number of years before cumulative cash flow equals initial investment

Question 3

What is the payback rule?

Answer 3

Only accept projects that pay back within desired time frame

Question 4

What is the formula for payback period?

Answer 4

Payback period = no. of years full recovery + uncovered cost/cash flow in last year before payback

Question 5

What does the payback rule not take into account?

Answer 5

It ignores the time value of money

Question 6

What is the NPV rule?

Answer 6

Managers only accept projects with a positive NPV

Question 7

What are mutually exclusive projects?

Answer 7

Taking one investment makes the other one redundant because they both serve the same purpose

Question 8

How do you choose between mutually exclusive projects?

Answer 8

Calculate each project’s NPV and choose the one with the highest NPV

Question 9

What is Internal Rate of Return (IRR)?

Answer 9

The discount rate that makes the project’s NPV = 0

Question 10

What is the formula for IRR?

Answer 10

0 = C_0 + C_1/(1+IRR) +…+ C_t/(1+IRR)^t

Question 11

What is the IRR rule?

Answer 11

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)

Question 12

What is the opportunity cost of capital?

Answer 12

Expected rate of return (of second-best investment alternative) given up by investing in a project

Question 13

When do NPV and IRR yield consistent results?

Answer 13

For independent investments

Question 14

Give 4 cases when NPV and IRR can yield different choices

Answer 14

• Borrowing vs lending
• Multiple IRR
• Mutually exclusive projects: investments of different scale
• Mutually exclusive projects: timing of cash flows

Question 15

Describe borrowing vs lending

Answer 15

Two projects may seem the same with identical IRRs but have different NPVs. Borrowing project accepted if IRR

Question 16

When may there be multiple IRRs?

Answer 16

If cash flow changes sign during project

Question 17

What is the formula for Profitability Index (PI)?

Answer 17

PI = NPV/Initial investment

Question 18

How do you choose between projects with capital constraints?

Answer 18

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

Question 19

How can the reinvestment rate problem be solved?

Answer 19

By using the modified internal of return, assuming project’s CF’s can be reinvested at discount rate r

Question 20

What is the use of PI?

Answer 20

It’s an alternative to NPV/IRR so to make projects of different scales comparable we need a relative measure