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Finance Chpt 5
Net Present Value and other Investment Criteria
Question | Answer |
---|---|
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 |