CAPITAL BUDGETING & INVESTMENT RULES (L4&5)

Question 1

Capital budgeting

Answer 1

Choosing projects that add value to the company
Independent: selecting one project to invest in doesn’t affect investing in another

Mutually exclusive: selecting one affects another, deciding to buy one coffee machine over a different one (only choosing one of the options)

Question 2

Net present value

Answer 2

To get cashflows (money from investment) there needs to be an initial investment
Npv= present value of future cash flows- initial investment
To find present value today use the discount rate
NPV tells us the value added to the business (positive is good)

Question 3

Payback period

Answer 3

Years it takes for the project to pay back the initial investment
Criterion using payback period: for independent projects, accept project if period k is less than threshold (max length)
For mutually exclusive: whichever has quicker payback rate

Question 4

Payback period cons

Answer 4

Doesn’t account for discount rate, compares different period of times
Cashflows after payback period ignored (NPV may be negative / risk is ignored)

Question 5

Payback period pros

Answer 5

Simple concept easy to calculate
Shows liquidity of project
Managers think it’ll get them quicker promotion

Question 6

Discounted payback period

Answer 6

Accounting for the time value of money, how long it takes to get back invested money
Sum of discounted cashflows CF/1+r + CF2/(1+r)^2 etc

Question 7

Discounted payback period pros & cons

Answer 7

Ignores cashflows after optimal cut off period
Considers time value of money

Question 8

Internal rate of return

Answer 8

rate of return for each year of the projects life
I0(initial investment)=C1/(1+IRR)^n

Question 9

Decision criterion using IRR

Answer 9

independent: IRR> opportunity cost of capital
mutually exclusive: highest IRR

Question 10

single period project
you construct a building for 100000 and expect it to sell for 110000, if the opp cost of capital is 6% do you accept the project?

Answer 10

I0=C1/(1+IRR)
100000=110000/(1+IRR)
1+IRR=1.1
IRR=10%, accept project

Question 11

multi-period
initial investment=800
cash inflow 300 for 3 years, 150 for 4th year

Answer 11

300/(1+IRR)+300/(1+IRR)^2+300/(1+IRR)^3+150/(!+IRR)^4)-800=0
trial and error

Question 12

IRR rules for borrowing and lending

Answer 12

when borrowing you want a lower IRR, higher when lending
borrowing is shown by a negative npv

Question 13

disadvantages of IRR

Answer 13

doesn’t account for the scale of a project so best to us NPV

Question 13

profitability index

Answer 13

when capital etc is limited, firms want the highest npv possible, PI=net present value/initial investment
independent: PI>0
mutual: highest PI