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FNCE317 > Ch 9-NPV > Flashcards

Ch 9-NPV Flashcards

1
Q

WHAT IS NPV

A

difference between investment market value and investment cost

it is a measure of how much value is cerated or added by undertaking an investmetn

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2
Q

what is capital budgeting all about

A

determining whether an investment is worthwile

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3
Q

capital budgeting and npv relationship

A

capital budgeting is looking for investments with positive npvs

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4
Q

when do we have to estimate npv

A

when there is no market to compare to (no housing market to compare house prices with etc)

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5
Q

how do we estimat npvs?

A
  • estimate the future cash flows that we expect to recieve “discounted cash flow valuation”
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6
Q

if the NPV is negative, the effect on share value would be
unfavourable. If the NPV is positive, the effect would be favourable.

A
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7
Q

if npv posititve: accept
if npv negative: reject

A
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8
Q

how to do a basic discounted cf valuation?

A
  1. draw a number line, and write out the cash inflow from each year
  2. discount them all to year one using number line method if varying cf, or the pv annuity formula if constant cf
  3. compare to cost
  4. if cost> cf= -npv
    if cost < cf= + npv
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9
Q

Payback meaning

A

the legnth of time it takes to recover og investment

How many years do we have
to wait until the accumulated cash flows from this investment equal or exceed the cost of the investment?

HOW LONG TILL WE BREAK EVEN

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10
Q

IF an investment pays itself back in 2 years what is the payback period

A

2 years

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11
Q

payback period rule

A

an investment is acceptable is payback is less than x amount of years

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12
Q

shortcomings of payback period rule

A
  • no objective basis to choose the x amount of years
  • no discounting involved so tvm is ignord
  • doesnt consider risk differences (payback would be the same for risk and non risk prohects)
  • requires arbitarry cutoff point and ignroes cash flows beyond the cutoff point
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13
Q

using a payback period rule tends to bias us toward shorter-term investments

A
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14
Q

pros of payback rule

A
  • good for ppl w no knowledge
  • used whwen cost of doing analysis is extra
  • it is good for general rules: like all investments less than 10k should have a 2 year payback
  • biased to liquidity
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15
Q

payback rule is biased towards short term projects, what does this imply?

A

it is biased towards liquidity!!!

and arguably it takes into account the risk of long term projects because only the more recent ones are guaranteed!!

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16
Q

. Because time value is ignored, you
can think of the payback period as the length of time it takes to break even in an accounting sense, but not
in an economic sense

A
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17
Q

discounted payback rule: modified payback rule

A

an inveestment is acceptable if its discounted payback is less than x amount of years

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18
Q

how to apply discounted payback rule?

A
  1. discount each years cash flow back
  2. create a new column called accuulated cash flow and add them up
  3. see when you have pacyback total

yr|cf(undisc)|cf(disc)|accf|(undisc)|acccf(disc)

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19
Q

payback rule

discounted payback rule

A

tells u when u break even accounting wise

tells u when u break even economic/financial wise

20
Q

discounted payback is a compromise between a regular payback and NPV that
lacks the simplicity of the first and the conceptual rigour of the second

A
21
Q

average accounting return

A

some measure of average acct proft/ some measure of avg acct value

22
Q

AAR= average net income/ average book value

A

Based on the average accounting return rule, a project is acceptable if its average accounting return
exceeds a target average accounting return

23
Q

cons of aar method

A
  • not a rate of return in any meaningful sense
  • it is the ratio of two acct numbers

-ignores tvm
- arbitrary way of choosing target AAR
- doesnt look at the right things (no focus on cash flow and market value, uses net income and book value)

24
Q

pros ofAAR

A

EASY TO CALCULATE
required info is usually available

25
Q

IRR

A

internal rate of return- single rate summarizing merits of a project

internal: focused only on the cf of a given investment no external rates

26
Q

Based on the IRR rule, an investment is acceptable if the IRR exceeds the required return. It should be
rejected otherwise.

A
27
Q

link between IRR nad NPV

A

IRR is the rate that results in NPV being 0 when IRR=r

28
Q

net present value profile.

A

the graph shows how NPV changes as the discount rate used changes.

when the npv is above x axis, it is all the discount rates wehre npv is positive

when the npv is below x axis it is all the discount rate where npv is negative

when npv crosses x axis it is the IRR

29
Q

DOES npv and irr always give the same decisions?

A

only if:
1. projects cash flow are conentional (first cf is negative) and the rest are positive

  1. project is independant and unrelated to other
30
Q

non conventional cash flows: when signs change more than once

A

This is because the NPV curve crosses the x axis twice=-> there are two IRRs

when more than one sign change: there are multiple rates of return

basically this happens when tehre is an initial negative outlay (cost to start up) and also negative outlay at the end

USE NPV RULE

31
Q

irr problems

A

1 two sign changes

#2 mutually exclusive investment decisions

32
Q

irr problem- mutually exclusive investment decisions

A

if u have two investments and u can only pick 1, you would pick th eone with the highest npv always, but NOT ALWAYS THE ONE WITH THE HIGHER IRR

any time we are comparing investments to determine which is best, IRRs can
be misleading

33
Q

MUTUALLY EXCLUSIVE INVESTMENTS- CROS SOVER RATE + HOW TO FIND IT

A

crossover rate= the discount rate that makes the npvs of both project equal

method #1: too calculate: compute IRR on the difference of the cash flows
1. set up a new column (inv a-inv b)
2. if the sign changes only once then calculate IRR!!!
3. you can figure out where IRR is by using the IRR funciton

method #2:
NPV(B-A) = -(extra money to invest in B) + (extra cf in b year 1)/1+r + (extra cf in b year 2)/(1+r)^2

set NPV(B-A)= 0 solve for IRR

34
Q

why do people choose IRR

A
  • people like talking about rates of return
  • easy to get
35
Q

cons of IRR

A

may result in mulitple answers/no answers with non conventional cf

may lead to incorrect decisions when comparing mutually exclusive investments

36
Q

profitiability index= beneft/cost ratio

A

PV of future cf/ initial investment

37
Q

pros and cons of profitbaility index

A

pros:
-similar to NPV, has same diecisions usually
-easy to get
- useful when avialble investment funds are limited

cons:
- may lead to wrong decision in comparing mutually exlcusive investments

38
Q

6 ways to do capital budgting6

A
  1. npv
  2. irr
  3. payback epriod
  4. discounte payback
  5. arr
  6. profitbaility index
39
Q

capitol rationing

A

complication in capital budgeting!
exsits when profitable (positive NPV) BUT we dont have the money to invest

so we do capital rationing

40
Q

soft rationing

A

when business units have x fixed amount of money every year

company as awhole isnt short on capitol, and more can be raised!

if this is a once in a while problem, try to choose projects with biggest NPV and highest PI index!

if this is achronic porblme something is up

41
Q

HARD rationing

A

company as a whole is short on money and cant raise any money under any circumstances

DCF analysis breaks down and no best course of action; if our requried rate of return is 20%, we usually take projects with greater return but if we have hard dationing we cant take any porjcets!!!

42
Q

AAR formula

A

AVERAGE NET INCOME/ AVERAGE BOOK VALUE

AVERAGE BOOK VALUE depends on how an asset is depreciated

43
Q

Modified IRR

A

3 methods:
1) DISCOUNTING APPROACH:
- discount all negative cf back to the present at the required return
-add them to the inital cost
:::::move all the negative cf to Y0

2) REINVESTMENT APPROACH:
-compound all cash flows (+ and -) except the first out to the end and then calc IRR
- CALCULATE THE FV
::::: move all the positive cf to Ylast

3) COMBO APPROACH:
-negative cf discounted to the present and positive cash flows are compounded to the end
::::move all the negative cf to Y0 and move all the positive cf to Ylast

44
Q

MIRRs and IRR

A
  • TOUGH bc diff ways to calculate IRR and no one knows which is better
    -ALSO you use an external rate which is no longer internal!!!
45
Q
A

FNCE317 (21 decks)

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