Week 17 - Corporate investment decisions: Net PV and other investment criteria Flashcards
1
Q
What is the payback period?
A
The time it takes to recover the initial cost of a project.
2
Q
How is the payback period computed?
A
Estimate the cash flows and subtract future cash flows from the initial cost until the investment is recovered.
3
Q
What type of measure is the payback period?
A
A “break-even” type measure.
4
Q
What is the decision rule for accepting a project based on the payback period?
A
Accept if the payback period is less than a preset maximum.
5
Q
Does the payback rule account for the time value of money?
A
No, the payback rule does not consider the time value of money.
6
Q
Does the payback rule account for the risk of cash flows?
A
No, it does not explicitly factor in the risk of future cash flows.
7
Q
Does the payback rule permit project ranking?
A
No, it does not allow for effective project ranking based on profitability.
8
Q
Does the payback rule indicate an increase in value?
A
No, it does not provide a direct indication of how much value a project adds.
9
Q
What is the biggest drawback of the payback period rule?
A
It focuses on recovering the initial investment rather than the impact on stock value.
10
Q
Should the payback rule be used as the primary decision rule?
A
No, because it does not account for value creation, time value of money, or risk.
11
Q
What are the advantages of the payback period method?
A
- Easy to understand
- Adjusts for uncertainty in later cash flows
- Biased towards liquidity
12
Q
Why is the payback period method easy to use?
A
It is simple to calculate and interpret without complex financial concepts.
13
Q
How does the payback period adjust for uncertainty?
A
By focusing on recovering costs quickly, it minimises reliance on uncertain future cash flows.
14
Q
How is the payback period biased toward liquidity?
A
It prioritises projects that return cash quickly, which is useful for firms needing short-term liquidity.
15
Q
What are the disadvantages of the payback period method?
A
- Ignores the time value of money
- Requires an arbitrary cut-off point and ignores cash flows beyond it
- Biased against long-term projects, such as R&D and new projects
16
Q
Why does the payback period ignore the time value of money?
A
It treats all cash flows equally, regardless of when they occur.
17
Q
Why is the payback period biased against long-term projects?
A
It favours short-term returns and undervalues projects with long-term benefits, such as R&D.
18
Q
Why is the payback period criticised for asking the wrong question?
A
It focuses on how quickly an investment is recovered rather than how much value it creates.
19
Q
A project has an initial cost of £42,700 and produces cash inflows of £8,000 per year for the first 2 years and £12,000 per year for the next 3 years. What is the payback period?
A
Year 1: £8,000 → Remaining: £42,700 - £8,000 = £34,700
Year 2: £8,000 → Remaining: £34,700 - £8,000 = £26,700
Year 3: £12,000 → Remaining: £26,700 - £12,000 = £14,700
Year 4: £12,000 → Remaining: £14,700 - £12,000 = £2,700
Year 5: £2,700 recovered from £12,000 → Fraction of year = £2,700 / £12,000 = 0.23 years
Total Payback Period = 4.23 years
20
Q
What is the Average Accounting Return (AAR)?
A
A financial metric that compares average net income to average book value.
21
Q
What is the formula for Average Accounting Return (AAR)?
A
AAR = average net income/ average book value
22
Q
What does the average book value depend on?
A
It depends on how the asset is depreciated.
23
Q
What is required for using AAR in decision-making?
A
A target cut-off rate must be set.
24
Q
What is the decision rule for AAR?
A
Accept the project if the AAR is greater than the target rate.
25
What is book value?
The balance sheet value of assets, liabilities, and equity, usually based on cost.
26
How does book value differ from market value?
Book value is based on historical cost, while market value is the actual price at which assets, liabilities, or equity can be bought or sold.
27
How is book value affected over time?
It is reduced by depreciation, a periodic charge which allocates the cost of an asset over its useful life.
28
What is the formula for net income?
Net income = revenue - expenses
for the period/ project
29
Does the AAR rule account for the time value of money?
No, AAR does not consider the time value of money.
30
Does the AAR rule account for the risk of cash flows?
No, AAR does not explicitly factor in risk.
31
Does the AAR rule indicate an increase in value?
No, AAR does not measure value creation or impact on market value.
32
Should AAR be used as the primary decision criterion?
No, because it ignores the time value of money, risk, and market value.
33
How does AAR treat the near and distant future?
It treats them equally, without discounting future values.
34
Why is AAR not a meaningful economic rate of return?
It is simply the ratio of two accounting numbers and does not reflect market value.
35
What are the advantages of the Average Accounting Return (AAR)?
1. Easy to calculate
2. Required information is usually easy to obtain
36
Why is AAR easy to use?
It relies on accounting data that is readily available.
37
What are the disadvantages of AAR?
1. Not a true rate of return – ignores the time value of money
2. Uses an arbitrary benchmark cut-off rate
3. Based on accounting net income and book values, not cash flows and market values
38
Why is AAR not a meaningful financial measure?
It does not consider cash flows, market values, or time value of money.
39
The Auto Shop is buying some new equipment at a cost of £218,900.
This equipment will be depreciated on a straight-line basis to a zerobook value its 8-year life.
The equipment is expected to generate net income of £36,000 a year for the
first four years and £22,000 a year for the last four years.
What is the average accounting rate of return?
BV_0 = 218,900
BV_8 = 0
ABV = (218900 +0)/2 = 109,450
ANI = (36000x4 + 22000x6)/8 = 29000
ARR = 29000/109450 = 26.5%
40
How do we calculate average book value?
ABV = (Initial cost + Ending book value)/ 2
41
What is Net Present Value (NPV)?
The difference between the present value of cash inflows and the initial cost of a project.
42
What does NPV measure?
How much value is created from undertaking an investment.
43
What is the first step in calculating NPV?
Estimate the expected future cash flows from the project.
44
What is the second step in calculating NPV?
Estimate the required return for projects of this risk level.
45
What is the third step in calculating NPV?
Find the present value of the cash flows and subtract the initial investment to get the net present value.
46
What are the 3 steps in calculating NPV?
step 1: estimate the expected future cash flows
step 2: estimate the required return for projects of this risk level
step 3: find the present value of the cash flows and subtract the initial investment to get the net present value
47
NPV example:
Project X needs initial outlay £1,100, and your required return is 10%.
Annual cash revenues and expenses are as follows:
t=0
project cost = -1100
t=1
project cost = 454.54
revenue = 1000
expenses = 500
free cash flow = 500
t=2
project cost = 826.45
revenue = 2000
expenses = 1000
free cash flow = 1000
NPV = -1100 + 500/1.1 + 1000/1.1ˆ2
NPV = -1100 + 454.54 +826.45
NPV = 180.99
48
What is the decision rule for Net Present Value (NPV)?
Accept the project if the NPV is positive.
49
What does a positive NPV mean?
The project is expected to add value to the firm.
The project will increase the wealth of the owners.
It is a direct measure of how well the project meets the goal of increasing shareholder wealth
50
What happens if the NPV is negative?
A negative NPV means the project will destroy firm value.
51
You are looking at a new project and have estimated the following cash
flows, net income and book value data:
Cash flows Y0 = -165,000
Cash flows Y1 = 63,120
Cash flows Y2 = 70,800
Cash flows Y3 = 91,080
If your required return for assets of this risk is 12%, discount the cash flows to obtain the NPV.
NPV = -165,000 + 63,120/ 1.12ˆ1 + 70,800/1.12ˆ2 + 91,080/1.12ˆ3
NPV = 12,627 > 0 accept
52
What does a positive NPV represent in terms of return of capital?
A positive NPV means the project will allow the company to pay back the £165,000 cost.
53
What does a positive NPV represent in terms of return on capital?
The project will provide at least a 12% return on the £165,000 investment over 3 years.
54
What does a positive NPV mean for shareholders?
After the project, the net gain in wealth for shareholders is £12,627.
55
Does the NPV rule account for the time value of money?
Yes, the NPV rule accounts for the time value of money by discounting future cash flows to their present value.
56
Does the NPV rule account for the risk of the cash flows?
Yes, the NPV rule incorporates risk by adjusting the discount rate (required return) based on the risk level of the project.
57
Does the NPV rule provide an indication about the increase in value?
Yes, a positive NPV indicates that the project will increase the firm's value by generating more cash than it costs to undertake.
58
Should we consider the NPV rule as our primary decision criterion?
Yes, NPV is the dominant method for making investment decisions as it directly measures the increase in shareholder wealth.
59
What does independent mean in the context of projects?
Independent projects have cash flows that are unaffected by the acceptance of other projects.
60
What is the decision rule for independent projects?
Accept all projects that meet the minimum acceptance criteria.
61
What does mutually exclusive mean in the context of projects?
Mutually exclusive projects mean that accepting one project precludes accepting the other.
62
What is the decision rule for mutually exclusive projects?
Choose the best project by ranking the alternatives and selecting the one with the highest value.
63
What is the minimum acceptance criteria for NPV?
Accept only projects with a positive NPV.
64
What is the ranking criteria for NPV?
Choose the project with the highest NPV, as it creates the most value.
65
What is capital rationing?
Capital rationing occurs when a firm has limited resources and cannot undertake all positive NPV projects.
66
What is soft rationing?
Soft rationing refers to temporary, often self-imposed resource limitations, where the firm may have more resources in the future.
67
What is hard rationing?
Hard rationing means that capital will never be available for the project, and there are no resources to invest in it.
68
How does the Profitability Index (PI) help when resources are limited?
The Profitability Index (PI) helps select the combination of projects that maximises the NPV using the available resources.
69
What is the Profitability Index (PI)?
The Profitability Index (PI) is a variation of NPV and is calculated as:
PI = NPV/ Investment
70
What is the general formula for the Profitability Index (PI)?
PI = Value created/ Resource consumed
71
What does a larger PI indicate?
The larger the PI, the greater the value of the project relative to the required investment.
72
What is a limitation of the Profitability Index (PI)?
the PI can rank projects incorrectly, especially when projects are mutually exclusive.
73
Why might we not prefer the Profitability Index (PI) over NPV?
There is little reason to prefer PI over NPV because NPV directly measures the value added to the firm, while PI can lead to incorrect rankings in some cases.
74
What is the Internal Rate of Return (IRR)?
IRR is the most important alternative to NPV and is widely used in practice for investment decision-making.
75
Why is IRR considered intuitively appealing?
IRR is intuitively appealing because it represents the rate of return at which the present value of cash inflows equals the initial investment, making it easy to understand.
76
What is the basis of IRR?
IRR is based entirely on the estimated cash flows of the project, with no need for external interest rates.
77
How is IRR similar to the yield to maturity of bonds?
IRR is similar to yield to maturity (YTM) because both represent the rate at which the present value of future cash flows equals the initial investment.
78
What is the definition of Internal Rate of Return (IRR)?
IRR is the discount rate that makes the NPV = 0. The formula is:
NPV = -C_0 + C1/(1+IRR)ˆ1 + C2/(1+IRR)ˆ2 +...+ Ct/(1+IRR)ˆt = 0
79
What does the IRR represent?
IRR represents the actual rate of return earned from an investment.
80
What question does IRR answer?
IRR answers the question: "What is the return on the investment?"
81
How does IRR compare to the required rate of return?
IRR could be higher or lower than the required rate of return, depending on the project.
82
What is the IRR decision rule?
Accept the project if the IRR is greater than the required return (also known as the hurdle rate).
83
What is another name for the required return?
The required return is also called the hurdle rate.
84
What is the ranking criteria for IRR?
Select the project with the highest IRR to maximise the return on investment.
85
How do you calculate IRR without a financial calculator or Excel?
Calculating IRR without a financial calculator or Excel involves a trial-and-error process by testing different rates until the NPV equals zero.
86
Chunky explanation:
The Internal Rate of Return (IRR) and Net Present Value (NPV) are two common methods for evaluating investment projects. The relationship between NPV and the discount rate (or required return) can be illustrated with an NPV profile.
Example NPV Profile
The NPV profile is a graph of the NPV of a project plotted against different discount rates. It shows how the NPV changes as the required return (discount rate) increases.
As the discount rate increases, the NPV decreases.
IRR as the X-axis Intercept
The IRR is defined as the discount rate at which the NPV of a project equals zero. This is where the NPV curve intersects the x-axis (the discount rate axis).
In the example above, the NPV becomes negative at a discount rate of 20%, and positive at 0%. The IRR is somewhere between 19.44% (approximated by the graph) and 20%, which means that at a rate of about 19.44%, the NPV would be exactly zero.
NPV Rule and IRR Rule
NPV Rule: The project is accepted if the NPV is positive, i.e., if the required return (discount rate) is less than the IRR.
IRR Rule: The project is accepted if the IRR exceeds the required return. In this case, if the required return is less than 19.44%, the project should be accepted because the IRR is greater than the required return.
In the example, both the NPV rule and the IRR rule lead to the same decision: Accept the project if the required return is below 19.44%.
Comments on the Example
Matching Decisions:
Both the NPV and IRR rules give identical accept/reject decisions in this case, as the NPV smoothly declines with the increasing discount rate, and the IRR is clear.
When NPV and IRR Rules Align:
The NPV rule and the IRR rule generally align when the NPV decreases smoothly as the discount rate increases. The decision rule is consistent, and both metrics suggest the same course of action.
Non-conventional Cash Flows and Multiple IRRs:
The rules may not always align if the project has non-conventional cash flows (i.e., multiple cash inflows and outflows occurring at different times). In such cases, the project may have multiple IRRs, making the decision ambiguous.
Mutually Exclusive Projects and Scale Problem:
When comparing mutually exclusive projects (where choosing one project excludes the others), there could be a conflict between NPV and IRR, especially when projects differ in scale (size). A project with a higher IRR may have a lower NPV due to being smaller in scale, leading to decisions that don't align with maximising shareholder value.
87
What are conventional cash flows?
Conventional cash flows have an initial negative cash flow (investment), followed by positive cash flows throughout the life of the project.
88
What are non-conventional cash flows?
Non-conventional cash flows occur when cash flows change sign more than once, with an initial negative cash flow (investment), followed by positive cash flows, and a final negative cash flow (closing the project).
89
Can non-conventional cash flows lead to multiple IRRs?
Yes, non-conventional cash flows can result in multiple IRRs because of the changes in the direction of the cash flows. Which IRR to use can become unclear.
90
What is an example of non-conventional cash flows?
An example would be a nuclear power plant or mine, where the cash flows initially are negative for investment, followed by positive cash flows during operations, and a final negative cash flow when decommissioning or closing the project.
91
What are some challenges with non-conventional cash flows and IRR?
Non-conventional cash flows can lead to:
Multiple IRRs: This makes it difficult to determine which IRR to use for decision-making.
No solution for IRR: Some cash flow patterns might not have any IRR solution.
The calculation of IRR becomes unreliable in such cases, making the decision process challenging.
92
How do you answer the question: "What is the return" for non-conventional cash flows?
For non-conventional cash flows, it is often better to rely on NPV or modified internal rate of return (MIRR) because IRR may not give a reliable result in such cases.
93
Example
Example: Multiple IRRs
In the example you’ve provided, we have a project with cash flows as follows:
Year 0: -£200 (initial investment)
Year 1: £200
Year 2: £800
Year 3: -£800
NPV Profile and Multiple IRRs
If we plot the NPV profile (as shown in the graph), the curve crosses the x-axis (NPV = 0) at two points, indicating two IRRs. These two discount rates are where the NPV equals zero.
The two IRRs are:
IRR 1 = 0%
IRR 2 = 100%
Interpretation of Multiple IRRs
When a project has multiple IRRs, the decision on which one to use depends on the context of the cash flows and the project characteristics. Here's a breakdown of why multiple IRRs might occur and how to handle them:
Non-conventional Cash Flows:
Multiple IRRs typically arise in situations with non-conventional cash flows—where the project has both negative and positive cash flows at different points in time (like in your example, where cash flows switch between positive and negative more than once). This leads to more than one rate where the NPV equals zero.
Graph Interpretation:
The NPV curve can cross the x-axis more than once, which is why there are two IRRs in your case. One is at 0% and the other is at 100%.
Which IRR to Use:
The higher IRR (100%) is typically the more relevant one for making decisions, as it corresponds to the discount rate where the project is likely to break even in terms of cash flows, assuming the project continues to earn positive returns after the initial investment.
The 0% IRR doesn't provide useful information for decision-making, as it doesn't represent a realistic required return or discount rate for the project.
Why Two IRRs?:
The two IRRs arise because the cash flows are alternating between negative and positive. The first IRR (0%) is a result of the project's initial negative cash flow, and the second IRR (100%) represents the point where the inflows and outflows balance, considering the project as a whole.
In Conclusion:
Which IRR to use? You should focus on the higher IRR (100%) for making the investment decision.
Why? This higher IRR reflects a more realistic rate that should be considered for evaluating whether the project is worth accepting, especially when cash flows are non-conventional.
94
What are the advantages of IRR?
Intuitively appealing: Often preferred by executives because it’s easy to understand.
Easy communication: Simple to explain the value of a project to stakeholders.
No required return needed: If the IRR is high enough, you may not need to estimate a required return.
95
What are the disadvantages of IRR?
Multiple answers: IRR can produce multiple solutions, especially with non-conventional cash flows.
Cannot rank mutually exclusive projects: IRR may fail to properly rank mutually exclusive projects that have different investment sizes and cash flow patterns.
Flawed reinvestment assumption: IRR assumes that cash flows are reinvested at the same rate, which is unrealistic and may distort decision-making.
96
Does the IRR rule account for the time value of money?
Yes, the IRR rule accounts for the time value of money because it is essentially the discount rate that sets the NPV to zero, which reflects the time value of future cash flows.
97
Does the IRR rule account for the risk of the cash flows?
No, the IRR rule does not explicitly account for the risk of the cash flows, as it assumes the same rate of return for all periods, regardless of changes in risk
98
Does the IRR rule provide an indication about the increase in value?
No, the IRR rule does not directly provide an indication of the increase in value of a project. It only indicates the rate of return, but it doesn't measure how much wealth or value will be added, as NPV does.
99
Should we consider the IRR rule for our primary decision criteria?
While the IRR rule is widely used and provides useful insights, it should not always be the primary decision rule because it has limitations, such as the potential for multiple IRRs and flawed reinvestment assumptions. NPV is generally a more reliable measure for shareholder wealth maximisation.
100
When will NPV and IRR give the same decision?
NPV and IRR generally give the same decision when the project has conventional cash flows (initial negative cash flow followed by positive cash flows) and when the projects are independent or follow the value additivity principle.
101
When can IRR be misleading?
IRR can be misleading in the following situations:
Non-conventional cash flows: When cash flows change signs more than once, IRR can give multiple results.
Mutually exclusive projects: When projects conflict in ranking, IRR may not give the correct answer (it may rank projects incorrectly compared to NPV).
Multiple IRRs: Non-conventional cash flows or cash flow patterns that change signs can result in multiple IRRs, making the decision difficult.
102
What happens with NPV in terms of value additivity?
NPV respects the value additivity principle, meaning that the combined NPV of independent projects is the sum of the NPVs of the individual projects. This makes NPV a reliable method for deciding on independent projects.
103
How do NPV and IRR compare when there is a conflict in ranking between mutually exclusive projects?
NPV is the preferred method when there is a conflict in ranking between mutually exclusive projects, as it correctly identifies the project that maximises value. IRR can rank projects incorrectly in such cases, leading to suboptimal decisions.
104
What is value additivity?
the principle that the total value of two independent projects should be the sum of their individual values.
When considering Net Present Value (NPV), the principle of value additivity holds true. However, Internal Rate of Return (IRR) does not follow this principle in the same way.
105
Example with NPV:
NPV of Project A (NPV_A): £2,790
NPV of Project B (NPV_B): £3,890
Combined NPV (NPV_A+B):
= NPVA +NVPB = 2790 + 3890 = 6680
In this case, the total NPV of the two independent projects (A and B) is the sum of the individual NPVs. This is an example of value additivity — the value of each project adds up when combined.
IRR of Project A (IRR_A): 18%
IRR of Project B (IRR_B): 9%
Combined IRR (IRR_A+B):
= IRRA + IRRB ≠ IRR(A+B)
The IRR rule doesn't adhere to value additivity because the IRR calculation is based on the timing and size of cash flows. Combining two projects with different cash flow profiles can result in a different IRR that doesn't reflect a simple arithmetic operation like adding or averaging the individual IRRs.
106
What are mutually exclusive projects?
Mutually exclusive projects are projects where the acceptance of one project precludes the acceptance of another.
For example, if you own a plot of land, you can either build a petrol station or a house on it, but not both.
107
What is the decision rule for NPV in mutually exclusive projects?
For NPV, the decision rule is to choose the project with the highest NPV because it will add the most value to the firm and maximise shareholder wealth.
108
What is the decision rule for IRR in mutually exclusive projects?
For IRR, the decision rule is to choose the project with the higher IRR, as it represents the higher return on investment.
109
Why might the best project not have the highest IRR?
The best project (in terms of increasing value) may not have the highest IRR because IRR does not account for the scale of investment. A project with a higher NPV but a lower IRR may be more valuable overall, even though it has a lower return percentage.
110
Example: Mutually Exclusive Projects
In this scenario, you have two mutually exclusive projects (A and B) that require an initial investment of £500 and £400, respectively. You only have £600 in hand, meaning you can only fund one of the projects. The required return (or discount rate) for both projects is 10%.
Let's analyse both projects using the provided IRR and NPV to determine which one to accept
Cash Flows:
Project A:
Period 0: -£500
Period 1: £325
Period 2: £325
Project B:
Period 0: -£400
Period 1: £325
Period 2: £200
Key Metrics:
IRR for Project A: 19.43%
IRR for Project B: 22.17%
NPV for Project A (at 10% discount rate): £64.05
NPV for Project B (at 10% discount rate): £60.74
Decision Criteria:
IRR: While IRR indicates the rate of return that makes the NPV equal to zero, it can sometimes give misleading results when comparing mutually exclusive projects, especially when projects differ in scale (i.e., the size of the initial investment). In this case, Project B has a higher IRR (22.17%) compared to Project A (19.43%), which might suggest Project B is more attractive.
NPV: The NPV rule is generally preferred over the IRR rule, especially for mutually exclusive projects, because it directly measures the value added to the firm by the project. Project A has a slightly higher NPV (£64.05) compared to Project B (£60.74). Since you can only choose one project, the NPV of £64.05 means that Project A will create more value for the firm.
Which Project to Accept?
Even though Project B has a higher IRR (22.17% vs. 19.43%), Project A has a higher NPV (£64.05) compared to Project B (£60.74).
NPV is the more reliable criterion for decision-making when comparing mutually exclusive projects because it reflects the actual value added by the project, taking into account the scale and timing of cash flows.
Conclusion:
Accept Project A because it has the higher NPV, which means it will provide more value to the firm, even though Project B has a higher IRR. The NPV rule should be prioritised when comparing mutually exclusive projects.
111
In this example, we have two projects (A and B) and their NPV profiles plotted against different discount rates. The key observation here is the crossover point, which is the discount rate at which the NPVs of both projects are equal.
Key Metrics:
IRR for Project A (IRR_A): 19.43%
IRR for Project B (IRR_B): 22.17%
Crossover Point: 11.8%
NPV Profiles:
NPV of Project A decreases as the discount rate increases, starting from a higher positive value and gradually declining.
NPV of Project B also decreases as the discount rate increases, but it may have a different pattern compared to Project A.
The crossover point occurs at a discount rate of 11.8%, meaning that at this discount rate, both projects have the same NPV. This point is crucial because it shows the threshold at which the preference between the two projects changes depending on the required rate of return.
Interpretation of the Crossover Point:
If the required return (discount rate) is below 11.8%:
Project A will have a higher NPV than Project B.
The NPV rule would recommend Project A over Project B.
IRR: Since IRR_A (19.43%) and IRR_B (22.17%) are both above 11.8%, they are both higher than the required return. However, Project B would still be preferred based on IRR, as it has the higher IRR (22.17%).
Ranking Conflict: In this case, there is a conflict between the NPV and IRR rankings. NPV would recommend Project A, but IRR would suggest Project B, because of its higher IRR (22.17% vs. 19.43%).
If the required return (discount rate) is above 11.8%:
Project B would have a higher NPV than Project A, as the NPV of Project A becomes lower at higher discount rates.
The NPV rule would now recommend Project B over Project A.
IRR: Since both IRRs (19.43% for A and 22.17% for B) are higher than the required return, both projects are acceptable, but the one with the higher IRR (Project B) would still be preferred based on IRR.
Conclusion: Ranking Conflict at Crossover Point
The crossover point of 11.8% is significant because it is the discount rate where the two projects have the same NPV. Below this point, NPV prefers Project A, while IRR prefers Project B due to the higher IRR of Project B.
Above 11.8%, both NPV and IRR would agree that Project B is preferable, as it has the higher NPV and IRR.
Ranking conflict occurs when the required return is below 11.8%, because NPV and IRR provide different recommendations. This highlights why the NPV rule is generally considered more reliable for decision-making, especially when the two metrics provide conflicting results.
In summary, the crossover point is the critical rate at which the decision changes between the two projects, and it underscores the potential for conflicting decisions between NPV and IRR when evaluating mutually exclusive projects.
112
Why do NPV profiles cross?
NPV profiles can cross due to two main reasons: size (scale) differences and timing differences.
113
How do size differences affect NPV profiles?
Smaller projects free up funds sooner, which can be reinvested.
The higher the opportunity cost (discount rate), the more valuable these early funds become.
NPV focuses on nominal value, while IRR focuses on the rate of return (e.g., 10% on £1,000 vs. 100% on £1).
114
How do timing differences affect NPV profiles?
Projects with faster paybacks provide more cash flows in the early years, which are valuable for reinvestment.
If the discount rate is high, early cash flows become especially valuable
115
What is the ultimate goal in project evaluation?
The ultimate goal is to create higher value for shareholders, and NPV is the preferred method for this as it directly measures value increase, while IRR may lead to misleading decisions.
116
Should we use IRR to choose between projects?
No, we should not use IRR to choose between projects, especially when projects are mutually exclusive or when NPV profiles cross, as NPV provides a more accurate measure of value creation for shareholders.
117
What should you do when there is a conflict between NPV and another decision rule?
Whenever there is a conflict between NPV and another decision rule (like IRR), you should always use NPV because it directly measures value creation and wealth increase for shareholders.
118
In which situations is IRR unreliable?
IRR is unreliable in the following situations:
Non-conventional cash flows (when cash flows change signs multiple times).
Mutually exclusive projects (when conflicting rankings arise between projects).
119
Can IRR offer any practical advantages over NPV?
Yes, IRR can offer practical advantages in cases where:
We cannot estimate the NPV unless we know the appropriate discount rate, but we can still estimate IRR.
120
When can IRR and NPV be considered interchangeable?
For stand-alone (independent) projects with conventional cash flows, IRR and NPV are interchangeable techniques, as both will lead to the same decision.
121
Should we only rely on the NPV rule for capital budgeting?
No, while NPV is the most reliable method, we should not rely solely on it. The biggest difficulty with the NPV rule is reliable cash flow estimates. Additionally, determining an appropriate discount rate can also be complex and uncertain.
122
What are the difficulties of the NPV rule in capital budgeting?
The main difficulties of the NPV rule include:
Reliable cash flow estimates: Accurate forecasting of future cash flows is challenging.
Determining an appropriate discount rate: Selecting the right discount rate for the project is not straightforward and can be influenced by market conditions, risk, and other factors.
123
Should we consider other investment criteria when making decisions?
Yes, it’s important to consider several investment criteria in addition to NPV. While NPV should be the primary tool for decision-making, other criteria like AAR and payback can provide additional insights, especially in terms of project risk and liquidity.
124
Should we use AAR and payback for final project decisions?
No, AAR and payback should not be used as the final decision rule because they don't fully account for the time value of money or long-term value creation. However, they should be carefully considered as they might indicate whether a project should be rejected, particularly if they suggest the project does not meet the minimum criteria for success.
