Unit 6 Decision Making Flashcards
Capital Budgeting Criteria
used to evaluate investments
NPV - net present value
IRR - Internal Rate of Return
PI - Profitability Index
NPV
difference between a projects present value of cash inflows and outflows
Indicates potential profit in today’s $ of a planned investment
Advantages of NPV
Accounts for time value of money
Determines value added to firm
Considers risk and required return
Disadvantages of NPV
Difficult to know appropriate cost of capital
Cannot be use to compare projects of different size
IRR
percentage return on an investment
The rate that would make NPV equal to 0.
Decision rule for IRR
If IRR > cost of capital, accept project
cost of capital = hurdle rate
Advantages to IRR
Easy to interpret
Considers Time Value of Money
Doesn’t need Rate of Return
Disadvantages of IRR
- Not a good indicator of value created
- Ignores mutually exclusive projects - can’t be used on its own to choose between one project or another
- Assumes Reinvestment at IRR
- Cannot Compare Projects with Different Durations
- Requires Conventional Cash Flows
NPV decision rule
If NPV is positive = accept
If NPV is negative = reject
PI
ratio of payoff to the investment amount
PI decision rule
Accept if PI > 1
Reject if PI < 1
Advantages of PI
same advantages of NPV
+ Can be used to choose between projects
Disadvantages to PI
Need cost of capital
not useful for mutually exclusive projects
Par Value
initial value of bond
value paid out at maturity
corporate US bonds usually $1000
Coupon Rate
aka coupon yield
interest rate on the bond
coupon
interest payment amount
YTM
yield to maturity
actual return on a bond when bought on the marketplace
covenants
affirmative - things bond issuer pledges to do to protect bondholders
Negative - things bond issues pledges not to do to protect bondholders