Unit 8 Flashcards
Once we are prepared to decide whether an investment project is worth undertaking or not, we require a decision rule, that is to say, ____________. Moreover, that method can help to decide which project is _________ when we have various selective projects.
a method to conclude when an investment is worth undertaking and when it is not
preferable
When evaluating an investment/financing project, we will have to check two issues:
- Is the investment financially VIABLE?
2. Is the investment PROFITABLE?
To find out if an investment is financially viable, we need to know if _____________. If so, the project __________, because _____________.
there is any lack of cash at any time during the life of the investment
will not be feasible
it will not be possible to face all the required payments
To assess if a project is or is not financially viable, we must ____________-.
check that the balance of the cash account in the balance sheet is ALWAYS positive
To know if an investment project is profitable, we must know ___________.
if it contributes to the increase of the wealth of the investor
In an investments timeline, “A” is always ________ in C0.
** A = initial investment
negative
In a financing timeline, “A” is always _________ in C0.
** A = initial investment
positive
In a financing timeline, we pay ____________ during the life of the project.
- Div.1
- Amort.1
- Int.1
In an investing timeline, we pay _____________ at the end of the investing project.
+Qn (cash flows from revenues and costs)
+VR (Residual value)
Total cash flows can be divided into:
- cash flows related to assets/investments
2. cash flows related to financing operations
Cash flows related to assets/investments are _____________.
the cash-flows that result from the purchase/sale of an asset, as well as the operations of the company.
The three types of cash-flows related to assets are ___________.
- The initial investment (A)
- The periodical cash-flows (Qi)
- The residual value (VR)
Periodical Cash-flows come from ______________.
the revenues and costs of the operations
The initial investment comprises _____________. This is usually a cash-___flow. We will symbolize it
by __.
the payments of the fixed assets and working capital purchases.
out-flow
A
The periodical cash-flows come from __________. We will symbolize them by ____.
the revenues and costs of the operations
Qi
And the residual value is the cash-flow from ________. It is symbolized by ____. This cash-flow, however, will usually be added to _____.
the disposal of the assets
VR
the last Qi (periodical cash flow)
Cash flows related to financing operations ___________. These cash-flows can be used to compute the ____________.
are produced by the receipt of the funds of the financing operations, as well as the payments of interests, dividends and principal repayments of those operations
cost of capital of the project
Some simple criteria that are used to form an approximate idea about the convenience of the investment project are ____________, because ______________.
not very reliable for decision making
their drawbacks are stronger than their advantages
Some examples of simple criteria are:
- The payback rule
2. Discounted payback rule
The payback rule is as follows:
The shorter the payback, the better the investment.
The payback is ___________.
the time until the cash-flows are equal to or exceed the value of the initial investment
Payback =
t/A = the sum of all periodical cash flows from 1 to t.
The advantages of the payback rule are __________.
- it is a simple and intuitive method that puts emphasis on the short term.
- because it is a simple and intuitive method, it is more useful when liquidity is important or when the longer-term cash flows are of high uncertainty.
The disadvantage of the payback rule is ___________.
- it does not consider the cash-flows after the payback, the time value of money, or how the investment has been financed.
The discounted payback is _____________.
the time until the sum of the discounted cash-flows equals or exceed the value of the initial investment
The discounted payback rule states that _____________.
The discounted payback is equal to t/A = the sum of the periodical cash flows (Qi) divided by (1+k)^i
The advantage of the discounted payback rule is ___________.
it is still a simple and intuitive method (though less simple than the payback).
The disadvantage of the discounted payback rule is ___________.
except for the time value of money, it does not consider the cash-flows after the payback or how the investment has been financed.
The Net Present Value (NPV) criterion is ____________. The NPV measures ____________, measured in monetary units valued at _________.
one of the most commonly accepted criteria for
capital budgeting
the increment in the company’s wealth produced
by the investment project
the beginning of the investment
NPV =
NPV = -A + (the sum of all periodical cash flows, Qi/(1+K)^i)
** where A = the initial investment and K = the discount rate calculated from the financing cash-flows of the project
In the NPV criterion, Qi represents ____________. It is important to note that these are __________. Also, the last cash-flow (Qn) will also include _____________.
“n” is _________, and “K” is _________.
The periodical cash-flows, which come from the revenues and costs of the operations.
the periodical cash-flows related to assets (no
financing cash-flow here).
the cash flows from the disposal of the assets at the end of the investment.
the term of the investment
K = the discount rate calculated from the financing cash-flows of the project
The NPV criterion states that ______________.
- A project will be worth undertaking if, and only if, its NPV is positive.
- The investment project with a higher NPV will be preferable to the investment project with a lower NPV
The advantages of the NPV criterion are ________________.
- It directly measures the variation of the wealth produced by the project.
- It takes into account the time value of money.
- It takes into account both the investment and its financing.
- It can be relatively easy computed.
The disadvantages of the NPV criterion are _______________.
- Problems arise for determining the preferable project when the initial investments differ (possible solution: NPV/A)
- Problems for determining the preferable project when the terms differ.
- The NPV criterion considers implicitly that all the cash-flows from assets are
reinvested at a rate of return equal to K.
A possible solution when problems arise in determining the preferable project when the initial investments differ is to ___________.
possible solution: NPV/A
divide the NPV by it’s initial investment
The criterion that eliminates the inconvenience that the NPV presents when it comes to ranking investments with different invested capitals and equal
duration is the ____________.
PROFITABILITY INDEX
PROFITABILITY INDEX (PI) =
PI = NPV/A
When selecting an investment using the NPV criterion, ___________.
Investment selection:
• > 0 Acceptable investment from the economic perspective
• <0 Reversible investment from the economic perspective
When hierarchizing investments using the NPV criteria, we rank ____________.
from highest to lowest ratio
The Internal Rate of Return (IRR) can be defined as _______________. It can be computed as ___________. That is to say, __________.
the average rate of growth of the value of the assets of the investment project per unit of time
the rate of discount that equates the asset-related cash-inflows to the asset-related cash outflows in the same period,
the rate of discount that would make the NPV equal to 0
IRR =
IRR = r/-A + (the sum of all periodical cash flows/(1+r)^i) = 0
The IRR criterion states:
- ______________. To make such a decision, ___________. Therefore, for an investment
to be worth undertaking, ____________. - _____________.
- The IRR taken in isolation cannot indicate if an investment is worth undertaking.
the IRR must be compared with a REQUIRED RATE OF RETURN, which is usually measured with the cost of capital of the project.
its IRR must exceed its cost of capital: IRR - K > 0
- The project with the higher IRR - K will be preferable to the project with lower IRR -K.
Advantages of the IRR criterion are:
- It takes into account the time value of money.
- It takes into account both the investment and its financing.
- It is a relative measure, so it can be used to compare projects with different initial investments.
Disadvantages of the IRR criterion are:
- Computation difficulties (–n degree polynomial)
- The IRR equation can have none, one or multiple solutions.
- Problems in determining the preferable project when the terms differ.
- The IRR criterion considers implicitly that all the cash-flows from assets are reinvested at a rate of return equal to the IRR.
When comparing the NPV and IRR, we can see that _____________.
- Both criteria coincide in determining if a project is or not acceptable: NPV > 0 == IRR > K
- The two criteria can differ when choosing the preferable investment:
Project B can have a higher IRR than project A,
so for any cost of capital, project B would be
preferable according to the IRR criterion.
However, if the cost of capital is K1, the NPV of
project A exceeds the NPV of project B, being
therefore preferable project A
One of the problems of both the NPV and the IRR is that ________________.
both criteria consider that the cash-flows are reinvested to an implicit rate of return (K and IRR, respectively)
What does it mean when we say the NPV and IRR both consider that cash-flows are reinvested to an implicit rate of return?
The company will reinvest it in other investments, so they will produce a given rate of return.
The NPV and the IRR criteria, implicitly, consider that ___________. The problem is, however, that ____________.
these cash-flows are reinvested
the rate of reinvestment used in these criteria may be not very realistic.
In the NPV, the reinvestment rate is equal to ___. If we consider that every Qi (periodical cash flow) is reinvested at a rate K till the term of the project, we will get the following:
K (the discount rate calculated from the financing cash-flows of the project)
-A + (the sum of all periodical cash flows (Qi) * (1+K)^n-i)/(1+K)^n = -A + the sum of all periodical cash flows (Qi) * (1+K)^-i = VAN
The IRR method considers that ___________.
the reinvestment rate is equal to IRR
In the NPV criterion, the reinvestment rate is equal to __, and the IRR method considers the reinvestment rate equal to ___. This difference in the reinvestment rates is the cause of the differences between both
methods in the hierarchical classification of projects.
K
the IRR
The assumptions of a reinvestment rate of K or IRR can be very _________. Consequently, we study how to compute the NPV or the IRR when the rate of return differs of those implicit rates. These criteria are known as the _____________.
unrealistic
Modified-NPV and Modified-IRR.
The Modified-NPV and Modified-IRR are used to ___________.
calculate the NPV or the IRR when the rate of return differs of those implicit rates.
Modified NPV: MNPV =
MNPV = -A + (the sum of all periodical cash flows (Qi)*(1+rir)^n-i/(1+K)^n
where rir = reinvestment rate
K = the discount rate calculated from the financing cash-flows of the project
Modified IRR: MIRR =
MIRR = r/-A + (the sum of all periodical cash flows (Qi)*(1+rir)^n-i/(1+r)^n = 0
The MNPV & MIRR consider that all the assets-related cash-flows are _________ and, consequently, they can be ___________. However, if we consider a project in which there is one (or various) Qi lower than zero, that amount of money ___________, but it will have
to be ________.
positive
reinvested at rir
cannot be invested
financed
If the periodical cash flows are less than 0, the reinvestment rate we should use is the ____________ instead of the _____. The formulas of the MNPV and MIRR then are the following:
cost of capital (K)
rir
MNPV = -A + (the sum of all periodical cash flows greater than 0 (Qi > 0)(1+rir)^n-i/(1+K)^n + (the sum of all periodical cash flows less than 0 (Qi < 0)(1+rir)^n-i/(1+K)^n
MIRR = r/-A + (the sum of all periodical cash flows greater than 0 (Qi > 0)(1+rir)^n-i/(1+r)^n + (the sum of all periodical cash flows less than 0 (Qi < 0)(1+rir)^n-i/(1+r)^n = 0
** where rir = reinvestment rate, A = initial investment,
K = the discount rate calculated from the financing cash-flows of the project
With the MVPV and MIRR methods, it is assumed that ______________. However, this assumption may be
unrealistic, given that ______________. Therefore, only the ____________ over the financial cash flow one would be really re-invertible.
all economic cash flows are reinvested until the end of the project
these cash flows must be used to cope with the financial cash flows that occur in the same period
excess of economic cash flow
If we calculate the increase in wealth that would occur considering that only excess cash flow over financial cash flow are reinvested, we will be calculating
the measure known as the _________. There is not, however, an equivalent measure for the IRR, given that ______________ (at moment zero, the economic and financial flows are exactly the same and of opposite signs).
Real NPV
if we perform this calculation, there will be no initial
disbursement of the project
Real NPV =
Real NPV = [(the sum of all periodical cash flows greater than 0 - FCFi) * (1+rir)^n-1/(1+K)^n] + [(the sum of all periodical cash flows greater than 0 - FCFi) * (1+K)^n-1/(1+K)^n]
cash flows =
revenues for period - costs for that period
At the end if a periodical cash flow, Qn, we expect ____________.
cash flows + residual value
Simple criteria adds things from different periods without considering anything.
True
Payback is the ___________; where cash flows = initial investment and rest after that is __________.
MOMENT at which I recover initial costs
benefits
Payback is when we ____________; that is the payback (not talking about money)
add to the initial investment the cash flows and see where sum = 0 or is positive
The discounted payback rule says that we ____________.
discount all the cash flows to moment 0 then calculate the payback
Interest to discount cash flows is ________, which must first be calculated (unit 7)
cost of capital
NPV is the __________ (measured in euros); we take __________.
money we get
all cash flows to moment 0 then subtract from negative initial investment (bcz outflow)
NPA = -A + NPV (rate; all cash flows from 1:n)
True
To discount just the cash flows, we use the _______ function in Excel.
NPV
Discounted payback is _____________.
when I recover my initial investment (discounting all values to C0)
Profitability index = NPV/_______ (which is A and must be a ______ value, and we use ____, so - = +)
We _____ if > 0.
initial investment
positive
-A
accept
PI is the _______________.
subcriteria of the NPV
IRR calculated from __________ gives cost of financiation, unit 7
financial cash flows
IRR calculated from ___________ (investment project) gives _________ (gives rate of increasing wealth of company)
internal cash flows
return on investment
“r” in the IRR formula is the ______________.
rate that makes everything 0
We must compare the IRR with something, so we use k (_____________)
cost of capital
If the return > cost of capital, we ________; if negative, we ________.
take it
leave it
bigger difference and positive IRR means _________ hierarchy
higher
From slide 12, blue line > green and red line = _______ and we _______ take it.
bad
won’t
Discounted Payback and Payback are part of the ________ criteria.
simple
NPV and PI are more _______.
realistic
