WEEK 2 - Investment Decisions

Question 1

What is the primary objective of companies investing?

Answer 1

Profitability

- Assets worth more than they cost

Question 2

Why do the valuation of assets have a projection on the future?

Answer 2

Expected to generate returns in the future periods

Question 3

What does the Present Value provide?

Answer 3

A measure that expresses future revenues in current terms

FV/(1+R) to the power of n

(CHECK SEM 1 NOTES)

Question 4

How do we calculate the present value over several periods?

Answer 4

Using the discounted cash flow formula

Sigma Ct/(1+rt) to the power of t

Where:

• Ct = Cash flow at period t
• rt = Rate of return on the asset at period t (or opp cost of the investment)
• T = Total Number of periods during which asset yields return

(SEE NOTES)

Question 5

What is the opportunity cost of capital?

Answer 5

The return foregone from a certain investment activity instead of investing to an alternative activity (with the same level of risk).

The parameter of r corresponds to this

Question 6

How do you calculate the NPV?

Answer 6

NPV = PV - Cost of Investment

SEE NOTES

Question 7

What is the decision rule of NPV?

Answer 7

Accept investments with a positive NPV

Question 8

How do we calculate the NPV over several time periods?

Answer 8

Sigma Ct/(1+Rt) to the power of t - Q0 - Sigma Qt/(1+Rt) to the power of t

(SEE NOTES FOR CLEARER VIEW)

Question 9

How do we calculate the Profitability Index?

Answer 9

Ratio of NPV to cost of investment:

PI = NPV/Q

Question 10

What are some interesting elements with the profitability index?

Answer 10

• Interesting when funds limited to invest in all projects with + NPV (Capital Rationing)
• PI picks projects with highest NPV per £ of initial investment

Question 11

What are the pitfalls of the Profitability Index?

Answer 11

1.possible bias against costly projects… although they may have a larger NPV.

2.resources/funds can be constrained in more periods.
cannot cope with mutually exclusive projects (eg: require the same piece of land, but different useful life),

3. or when one project is dependent on another (eg: one is an add-on to the other).

Question 12

What is the Book Rate of Return?

Answer 12

Prospective book income as a proportion of the book value of the assets that the firm is proposing to accquire
Accounting measure of the return of an investment

Question 13

How do you calculate the Book Rate of Return?

Answer 13

BRR = Book Income/Book Assets

Question 14

What are the pitfalls of the Book Rate of Return?

Answer 14

1. bias against more costly projects with higher NPV;
2. average profitability of past investments is not the right hurdle for new investments;
3. depends on which items the accountant treats as capital investment (and how rapidly they are depreciated) and which items are operating expenses;
4. therefore, an accountant’s classification of cash flows, may yield different results.

Question 15

What is the Payback period method?

Answer 15

Measures the no of years takes for cumulative cash flow from the project to equal initial investment

• A project should be accepted if payback period is less than some specific cut-off period

Question 16

What are the pitfalls of the Payback period method?

Answer 16

1. all cash flows after the cut-off date are ignored (although they may be significantly high);
2. all cash flows before the cut-off date are treated equally (without taking account of discounting).

Question 17

What is the Internal Rate of Return (IRR)?

Answer 17

The rate of discount that makes NPV = 0

Question 18

How do you calculate the IRR?

Answer 18

NPV = Sigma Ct/(1+IRR) to the power of T - Q = 0

Need to figure out what number is the IRR

• Hard to pinpoint exactly what the IRR is

Question 19

What is the Investment Rule for the IRR?

Answer 19

If the IRR is greater than the actual opp cost of capital (r) (IRR>r) then project should be undertaken

Question 20

How can we find the IRR?

Answer 20

Trial and Error process

Try dif discount rates (10,30,50%) until get NPV = 0

If NPV negative then IRR too high

Question 21

What are the pitfalls of the IRR?

Answer 21

1. In the case of borrowing money, the IRR rule work the other way round i.e
   Opp Cost > IRR
2. When project incurs some future costs, there may be multiple IRRs or even none
3. When more than one opp cost of capital obtaining the IRR becomes even more complex.
   i. e Do we compare IRR with R1,R2,R3 or with weighted average of Rs
4. Can be misleading with mutually exclusive projects
   - IRR is unreliable in ranking projects of dif scale
   - Unreliable with dif patterns of cash flow over time

Question 22

What is the rate of return?

Answer 22

The ratio of the project’s profitability,

-The difference between its future cash flows (or payoff) and the cost of investment divided by the cost of the investment.

Question 23

What is the rate of return rule?

Answer 23

“Accept investments that offer rates of return in excess of their opportunity costs of capital, i.e. if
RR >r ..”

Question 24

How do you calculate the Rate of Return?

Answer 24

RR = C-Q/Q