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Finance Chpt 5

Net Present Value and other Investment Criteria

QuestionAnswer
NPV - Investment Rule Accept project if NPV is +ve. For mutually exclusive projects, choose the one with the highest (+ve) NPV.
NPV - Comments Gold standard of investment criteria. Only criterion consistent w. maximising the value of the firm. Provides proper rule for choosing amoung mutually exclusive investments. Only pitfall involves capital rationing - one cannot accept all + NPV projects.
IRR Definition The discount rate at which project NPV = 0
IRR - Investment Rule Accept project if IRR is greater than opportunity cost of capital.
IRR - Comments Same accept-reject decision as NPV in the absence of project interactions. Pifalls = IRR cannot rank mutually exclusive projects (project w. higher IRR may have lower NPV) & the IRR rule cannot be used with multiple IRRs or an upwards sloping NPV profile.
Payback period Definition Time until the sum of project cash flows = the initial investment
Payback - Investment Rule Accept project if payback period is less than some specified number of years.
Payback - Comments A quick and dirty rule of thumb, with several critical pitfalls. Ignores cash flows beyond the acceptable payback period. Ignores discounting. Tends to improperly reject long-lived projects.
Profitability Index Definition Ratio of NPV to initial investment
Profitability Index - Investment Rule Accept project if profitability index is greater than 0. In case of capital rationing, accept projects with highest profitability index.
Profitability Index - Comments Results in same accept-reject decision as NPV in the absence of project interactions. Useful for ranking projects in case of capital
Opportunity Cost of Capital Expected rate of return given up by investing in a project
Risk and Present Value Higher risk projects require a higher rate of return Higher required rates of return cause lower PVs
Investment timing Sometimes you have the ability to defer an investment and select a time that is more ideal at which to make the investment decision. E.g. you may defer the harvesting of trees, by doing so, you defer the receipt & increase the cash flow
Equivalent Annual Cost The cash flow per period with the same present value as the cost of buying and operating a machine.
Capital Rationing Limit set on the amount of funds available for investment.
Soft Rationing Limits on available funds imposed by management (not by investors).
Hard Rationing
Created by: wguate