Week 2 - Discounted Cash Flow Flashcards
Define Hurdle rate
Hurdle rate is the minimum rate of return required by the person(ceo for example)/organisation making the investment
Define opportunity cost
Is the value of the best alternative scheme not done as a result of doing the chosen scheme
Define inflation
Is the rise in price over time, effectively eroding value
What is a sunk cost?
A cost already incurred which is irrecoverable. Thus irrelevant for financial appraisal of projects
What is considered when making investment decisions?
Investment decision making mainly considers the financial elements of a decision. However, it can also consider other factors such as economic, environmental, political and personal ambitions of higher ups in an organisation
How do we decide on a discount rate to use? (4)
• How patient the investor is - how quickly do they want their money?
• The risk attributed to the investment
• Inflation levels which have to be “overcome”
• Investor Knowledge - how well do they know the market/the speculator
How do you find the Net Present Value (NPV) when not given the discount rate?
• Guess the discount rate starting with 10% and going either side until you get an NPV which is between + and - figures
Define Internal Rate of Return (IRR) (3)
• Is the discount count rate where the NPV is zero
• is the annualised rate of return for a project
• Is expressed as a percentage
How do you workout the Internal rate of return (IRR)? (4)
1 - Get the NPV for an investment with different discount rates (10% for example) making sure you have just above positive and just below negative values (get 3 values)
2 - Plot these values on a graph which has NPV on the Y-axis and discount rates on x-axis
3 - Draw a curve that goes through the 3 points as closely as possible
4 - the IRR is the discount rate where the NPV is zero
What impact does the internal rate of return (IRR) have on investment decision making? (2)
• IRR can be used instead of taking the highest (or lowest) NPV where an investment could focus on reducing losses e,g, government departments such as hospitals etc
• An investment decision can be made (doing the investment) if the IRR is greater than the hurdle rate
How does the hurdle rate (HR) and the Internal Rate of Return (IRR) impact whether to proceed with an investment?
If the internal rate of return (IRR) is greater than the hurdle rate then recommend proceeding with the investment but if it is lower than do no proceed - on a graph if the IRR is to the right of hurdle rate then proceed but if it to the left do not
How do you workout the initial discount rate to use in an IRR question? (2)
1 - By calculating the average % annual profit for the scheme. Formula is:
Tips on how to get a discount rate closer to zero in an IRR question
If the NPV is greater than 0 make the discount rate smaller but if the NPV is smaller than 0 make the discount rate bigger
Tip on plotting the first 1/2 points of the NPV-Discount rate graph for an IRR
• Workout the average % annual profit for the initial NPV discount rate but if it’s far from zero do the second NPV with a discount rate of 10
What is the formula for the NPV
Tips for answering the internal rate of return questions (3)
• Use the average annual% profit to get the first discount rate
• If the 1st NPV is negative use a smaller discount rate and if the 1st NPV is positive use a bigger discount rate
• With the graph curve have it drawn with the possibility of intercepting the y-axis
How do you answer the second part of an IRR question?
Steps to answering IRR questions
