Basics of Project Evaluation Flashcards
(24 cards)
What does capital budgeting do?
- determines strategic direction of the firm
- analyses the potential projects for the firm
such as initial expenditures, cash flow projections and risk considerations
What is NPV?
Net present value -the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
What is NPV in a stand-alone project?
For a stand-alone project, NPV answers this question:
“Will this project, by itself, generate more money than it costs, after accounting for the time value of money?”
is used to determine whether that specific project is financially viable on its own, without comparing it to other alternatives.
How do you find how much value is created from undertaking an investment (stand-alone)? (How do you calculate NPV)
1) estimate the expected future cashflows
2) estimate the required return for the projects of this risk level
3) find the present value of the cashflow and subtract the initial investment to arrive at the net present value
NPV formula
1) NPV = PV inflows - costs
2) NPV=∑(CF_t/((1+R)^t)-CF_0)
NPV Decision rules
NPV > 0 Accept project (expected to add value to the firm and increase the wealth of the owners)
What is IRR rule?
Internal rate of return rule:
the discount rate that makes the NPV = 0
How do we find the IRR?
- trial and error until NPV equals 0
- using excel spreadsheet function =IRR()
- financial calculator
What situations will the IRR and NPV rule conflict?
- delayed investments
- nonexistant IRRs
- multiple IRRs
in what situations is IRR unreliable?
- non-conventional cashflows
- mutually exclusive projects
Advantages of IRR
- intuitively appealing
- simple to communicate to someone who doesn’t know all the estimation details
- if IRR is high enough, you may not need to estimate required return which is often a difficult task
Disadvantages of IRR
- cannot produce multiple answers
- cannot rank mutually exclusive projects
- reinvestment assumption is flawed
What is the payback rule?
a measure of how long a project takes to recover the initial cost of that project
how do you compute the payback?
1) estimate cashflows
2) subtract the future cashflows from the initial cost until the initial investment is recovered
3) A break even type measure
what is the decision rule for the payback rule?
accept if the payback period is less than some pre-set limit
Advantages of the payback rule
- easy to understand
-adjusts for uncertainty of later cashflows - biased towards liquidity
disadvantages of the payback rule
- ignore the projects cost of capital and the time value of money
- requires an arbitrary cut-off point
- ignores cashflows after the payback period
- biased against long-term projects, such as research and development and new projects
what is the profitability index?
a measure of the benefit per uni cost on the time value of money
what is the decision rule?
PI > 1.0, accept
since a profitability index of 1.1 implies that for every $1 of investment, we crease an additional $0.10 in value
advantages of the profitability index
- closely related to NPV
- easy to understand and communicate
- may be useful when available investment funds are limited
disadvantages of the profitability index
- may lead to incorrect decision in comparisons of mutually exclusive investments
What are mutually exclusive projects?
projects where selecting one project automatically prevents the selection of the others
Why IRR isn’t favorable in choosing mutually exclusive projects
- IRR cannot be used to compare projects of different scales (e.g. if project size doubles, NPV can double, but IRR can’t)
- IRR can be affected by changing the timing of cashflows
- An IRR is not attractive for a riskier project
what is mostly used in practice of capital budgeting?
- NPV and IRR (primary investment criteria)
- payback rule (secondary investment criteria)
