week 17 Flashcards
what are good decision criteria
have all cash flows been considered
has the time value of money been taken into account
has risk been adjusted for
does the decision rule enable you to rank projects
does the decision rule provide information on whether it will create value for the firm
what is the payback period
how long it takes to recover the initial cost of the project
how do you calculate payback period
estimate cash flows
initial cost - future cash flows until initial investment is recovered
accept if payback period is less than a pre-set max
should we use payback as the primary decision rule
biggest drawback is that the issue is the impact of investment on stock value, not how long it takes to recover money
what are the pros of payback
easy to understand
adjusts for uncertainty in later cash flows
biased towards liquidity
what are the cons of payback
ignores time value of money
requires an arbitary cut-off point and ignores cash flows beyond the cut-off date
biased against long term project such as R&D and new projects
what is average accounting return (AAR)
money made or lost over a given period
how do you calculate AAR
average net income / average book value
what is book value
the balance sheet value of assets, liabilities and equity, usually based on cost
what is market value
true value, the price at which assets, liablities or equity can be bought or sold
what is net income
revenue - expenses for the period
should we use AAR as primary decision criteria
AAR treats near and distant future as the same, no discounting or meaningful economic rate of return
what are the pros of AAR
easy to calculate
required info is usually easy to obtain
what are the cons of AAR
not a true rate of return, ignores time value of money
uses an arbitary benchmark cut off rate
based on accounting net income and book values, not cash flows and market values
what is net present value (NPV)
the difference between the present value of cash inflows of a project and its cost
how do you calculate NPV
sum of Ct / (1+r)^t
what is the NPV decision rule
NPV > 0, accept project as it adds value to the firm and increases owner wealth
direct measure of how well the project will increase shareholder wealth
accepting NPV < 0, will destroy firm value
what does positive NPV mean
return of capital - pay back cost
return on capital - get a return payment
value for shareholders - net gain of wealth
should we use NPV as the primary decision criteria
yes
what is an independent project
cash flows of one project are unaffected by acceptance of another
accept all projects which meet minimum acceptance criteria
what is a mutually exclusive project
the acceptance of one project precludes accepting the other
choose best project by ranking the alternatives
how do you use the NPV decision rule
minimum acceptance criteria - only take projects with positive NPV
ranking criteria - choose the project with the highest NPV
what is the profitability index
a company has limited financial resources and cannot finance all available projects
helps select project combinations and alternatives
helps identify which combination of projects maximises NPV from investment
what is capital rationing
firms have limited resources and cannot undertake positive NPV projects
soft rationing - limited resources are temporary and usually self imposed
hard rationing - capital will bever be available for this project
how do you calculate PI
NPV / investment
or
value created / resource consumed
larger PI measure, greater value of the project given required investment
rank projects incorrectly where they are mutually exclusive
what is internal rate of return (IRR)
alternative to NPV
widely used
based on estimated cash flows
independent rates of interest
similar to YTM
its is a discount rate the sets NPV = 0
how do you calculate IRR
sum of Ct / (1+IRR)^t = 0
what is the IRR decision rule
accept the project if IRR is greater than required return
ranking criteria - select alternative with highest IRR
what are the pros of IRR
often preferred by exectutives, it is intuitively appealing
eacy to communicate vlaue of a project
if IRR is high enough, may not need to estimate required return
what are the cons of IRR
can produce multiple answers
cannot rank mutually exclusive projects
reinvestment assumption flawed
when do you use NPV vs IRR
conventional cash flows, independent - NPV
conventional cash flows, mutually exclusive - conflict
non-conventional, independent - IRR
non conventional, mutually exclusive - IRR, conflict
what is value additivity
when the value of a whole group of assets exactly equals the sum of values of individual assets that make a group of assets
why do NPV profiles cross
size differences - smaller project free up funds sooner than investment, higher opportunity cost more valuable the funds so high discount rate favours small projects
timing differences - project with faster payback provides more cash flow in early years of reinvestment
discount rate is high, early cash flow especially good
what is the scale problem
NPV focuses on increase in nominal value
IRR focuses on rate of return
ultimately interested in creating higher value for shareholders, use NPV to choose between projects
what are the conflicts between NPV and IRR
always use NPV if there is a conflict
IRR is unreliable if it is non-conventional cash flows or mutually exclusive projects
IRR can sometimes have practical advantages
should we only use NPV
difficulty of NPV is coming up with reliable cash flows estimates
determining appropriate discount rate can be hard
should consider AAR and payback to make final decision
