Investment analysis

Question 1

NPV

Answer 1

The net present value of a project or investment is the difference between the present value of its benefits and the present value of its costs.

Question 2

IRR

Answer 2

The internal rate of return is the discount rate that makes the net present value equal zero
- rule: take any investment where the IRR exceeds the cost of capital. Turn down any investment whose IRR is less than the cost of capital.

• As the IRR is a rate of return, one cannot compare projects of different scale.

Question 3

IRR vs NPV

Answer 3

The IRR rule works for a stand-alone project if all of the project’s negative cash flows precede its positive cash flows (= “normal” cash flow projects) -> in other cases, the IRR rule may disagree with the NPV rule and thus be incorrect.

Question 4

Pitfalls of the IRR rule

Answer 4

1. delayed investments
2. multiple IRR
3. nonexistent IRR

Question 5

IRR versus the IRR rule

Answer 5

While the IRR rule has shortcomings for making investment decisions, the IRR itself remains useful.
- IRR measures the average return of the investment. Hence, it is an exact measure for the average ROIC of a project of its lifetime
- IRR can be used to check the sensitivity of the NPV to any estimation error in the cost of capital

Question 6

Mutually exclusive projects

Answer 6

When you must choose only one project among several possible projects, the choice is mutually exclusive
(Select the project with highest NPV, highest IRR may lead to mistakes)

Question 7

Payback rule

Answer 7

The payback period is amount of time it takes to recover or pay back the initial investment (rule: if the payback period is less than a pre-specified length of time, you accept the project. Otherwise reject.)

Question 8

Application of payback rule

Answer 8

Payback rule is used by many companies because of its simplicity. This is a widespread method in practice. Maybe, because firms often care more about the liquidity drain of a project rather than its profitability.

Question 9

Shortcomings of the payback rule

Answer 9

• Ignores the project’s cost of capital and time value of money
• Ignores cash flows after the payback period
• Relies on ad hoc decision criterion

Question 10

Profitability index

Answer 10

The profitability index can be used to identify the optimal combination or projects to undertake. Companies use it for the evaluation of projects with different resource constraints. (PI = Net present value / resource consumed = value created / resource consumed)

Question 11

PI rule

Answer 11

When choosing among project competing for the same resource, rank the projects by their profitability indices and pick the set of projects with the highest profitability indices that can still be undertaken given the limited resource.

Question 12

Shortcomings of PI

Answer 12

• In some situations the profitability index does not give an accurate answer
• One would have to enumerate the different combinations in order to find out the NPV maximizing combination.
• With multiple resource constraints, the PI index can break down completely