7. Evaluating flows of money Flashcards
(23 cards)
What is time preference?
The concept that receiving money earlier is preferred over receiving it later due to its present value.
How can a project be financially viewed?
As a sequence of cash flows occurring over time.
What are the basic requirements for a viable project?
Return the investment, cover the cost of money, and generate additional earnings.
What are the common sources of project funding?
Owners’ capital, reserve capital, and loan capital.
What is opportunity cost in project evaluation?
The lost benefit from investing resources in an alternative option.
Define Payback Period.
The time it takes to recover the initial investment.
How is Return on Investment (ROI) calculated?
(Total returns - Initial investment) ÷ Initial investment.
Why are simple methods like ROI limited?
They ignore time preference and the changing value of money.
What is the interest rate?
The amount earned or paid for the use of money over time.
What is the discount rate?
The rate used to convert future money into its present value.
How is Net Present Value (NPV) calculated?
NPV = Future cash flow × (1 + r)^-t, where r is the discount rate and t is time.
What is the Minimum Acceptable Rate of Return (MARR)?
The lowest rate of return an investor is willing to accept, also called the hurdle rate.
What factors influence the MARR?
Interest rates, inflation, risk allowance, and investor expectations.
How is MARR applied?
By discounting each cash flow and summing the discounted values to assess viability.
What is the main weakness of MARR?
It relies on choosing an arbitrary discount rate.
What does IRR stand for?
Internal Rate of Return.
What is the IRR?
The rate at which the NPV of all cash flows equals zero.
Why is IRR useful?
It avoids setting an arbitrary rate and indicates project profitability.
How is IRR found?
By testing different discount rates until cumulative NPV = 0.
How can IRR be compared to bonds?
IRR is equivalent to the interest received on a fixed income investment.
What is an inflation-adjusted NPV?
Future cash flows are deflated using the inflation rate before discounting.
What if IRR and NPV give different project choices?
Investors use judgment, considering investment amount, cash return, and individual needs.
What three key concepts does this lecture cover?
Time preference, NPV discounting, and MARR/IRR methods.
