Topic 7 - Capital Budgeting Decision Flashcards
NPV decision rule (for a single stand alone project)
if NPV > 0, then accept
if NPV < 0. then reject
Maximum Estimation Error
the difference between the IRR and the true cost of capital, the maximum estimation error that can exist without altering the initial position
IRR decision rule
the internal rate of return is the discount rate at which the NPV is 0. we calculate is using trial and error, then interpolation.
if IRR > 0 reject
if IRR < 0 accept
Interpolation Formula
IRR = rlow +
(NPV low / NPV low - NPV high) x (rhigh-rlow)
Limitations of IRR
- Delayed investment
- Sometimes there is no IRR
- Sometimes there are multiple IRR’s
NPV or IRR?
When they provide conflicting answers, then we follow the NPV rule
Delayed investment impact on IRR rule
When the benefits of an investment occur before the costs, the NPV and the IRR will conflict in this scenario.
Multiple IRR’s impact on IRR rule
This is a situation where the cash flow is unconventional as it switches between positive and negative, creating multiple crossover points ie IRRs
No IRR, impact on IRR rule
In some cases we have no IRR at all, in this case we can’t apply this rule
Payback Period
the amount of time it takes to recover or pay back the initial investment
if PB period < specified time scale, then accept
if PB period > specified time scale, then reject
PB period formula
PB = Years before cost recovery + Remaining cost / CF during the year
Limitation of the Payback Rule
- it ignores the project’s cost of capital and time value of money
- it ignores cash flows after the PB period
- it relies on AD HOC decision criterion ie. what is the right amount of time to require for the PB period?
Comparison of IRR and NPV
BOTH
- account for time value of money
Investment Size
- NPV takes this into account
- IRR fails to measure wealth changes
Additivity
- NPV is possible
- IRR isnt possible
Profitability Index + formula
when resources are limited, the profitability index provides a tool for identifying the optimal combination of projects to undertake
PI = NPV / resource consumed
Pitfalls of Profitability Index
- it doesn’t optimize the available resources
- with multiple resource constraints, the PI breaks down completely
