Tutorial 1 Flashcards
What is the NPV Approach?
What year is the initial investment cost always in?
The initial investment cost C0 is always in Year 0
What is a Payback period calculation?
The time required to recover the initial investment from the project’s cash flows.
Steps:
- Identify Initial Investment: (Year 0 cash flow, usually negative)
- Identify Annual Cash Flows: (Positive inflows for subsequent years)
Cumulative Cash Flow:
- Add cash inflows year by year until cumulative cash flow ≥ initial investment.
Payback Period:
The year when cumulative cash flow becomes positive.
Advanatages of NPV Over BPP
Advantages of NPV:
Time Value of Money:
Accounts for the time value of money, recognizing that money today is worth more than the same amount in the future.
Comprehensive Profitability Measure:
Provides a direct measure of the added value to the firm by considering all cash flows and the cost of capital.
Decision Rule:
A positive NPV indicates a profitable project, whereas a negative NPV suggests that the project should be rejected.
Flexibility:
Can handle varying cash flows over time, unlike PBP which simply sums them until the initial investment is recovered.
What is the profitability index?
How do we calculate subtracting the initial investment C0 in the NPV calculation?
CO is often the first term in the NPV calculation as we often start with the Present Value in ascending order, and since there is no discounting for year 0 and it is a net cash outflow it ends up getting subtracted by default
Do you need to use the discount factor table if you have a calculator?
No you do not, you can just use your calculator
Why is NPV critical in investment decisions?
In investment decisiions, NPV is critical as it directly reflects the potential increase in shareholder value. If a manager is to bypass a project with a positive NPV, they forfeit that increase.
