Lecture 2

Question 1

Which are the investment decision methods?

Answer 1

Payback period
Break-even analysis (Internal Rate of Return)
Net Present Value

Question 2

Name five pitfalls with using IRR for when evaluating an investment

Answer 2

Pitfall 1: investment has positive cash-flow now, and negative cash-flows later

Pitfall 2: IRR could be not unique

Pitfall 3: IRR could just simply not exist

Pitfall 4: Timing differences (short vs long projects)

Pitfall 5: Risk differences (IRR must be adjusted for risk premium)

Question 3

Name two pitfalls of using the payback period when evaluating investments

Answer 3

1. Ignores cost of capital and time value of money

2. Ignores cash-flows after payback period

Question 4

How is it a joint effort of several divisions to calculate incremental earnings of an investment?

Answer 4

– Marketing will need to forecast the increase in revenue, and the advertising expenses

– Accounting will have to calculate the tax implications

– Personnel: estimate personnel requirements and costs

– Operations: suggested equipment and hardware

– Finance: cost of capital, valuation

Question 5

What effect can an investment have on taxation?

Answer 5

Since the investment includes an expense or a cash outflow, there is simply less money left to tax. This must be deducted from taxation (sometimes resulting in negative taxation)

Question 6

How are Free Cash Flows calculated from an income statement?

Answer 6

Net Income
+ (add back) Depreciation
- (deduct) Capital Expenditures
- (deduct) Increase in Net Working Capital