Flashcards in Chapters 2&3: Decision Rules Deck (16):

1

## Three processes in any cash-flow analysis

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1. Identification

2. Valuation

3. Comparison

2

## Conventions in representing cash flows

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- Initial or 'present' period is always year 0

- Year 1 is one year from present year

- All amounts accruing during a period are assumed to fall on the last day of the period

3

## Comparing costs and benefits

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- We cannot compare dollar values that accrue at different points in time - to compare we use the concept "discounting"

- Reason: $1 today is worth more than $1 tomorrow

4

## Discount Factor

### 1/(1+i)^n

5

## Future Value

### FV=PV*(1+i)^n

6

## Present Value

### PV=FV/(1+i)^n

7

## Net Present Value

### Found by subtracting the discounted value of project costs from the discounted value of project benefits

8

## NPV Decision Rule: Accept vs Reject Decisions

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If NPV =>0: accept

If NPV<0: reject

Choose larger NPVs

9

## Changing the discount rate

### As the discount rate increases, the NPV increases

10

## IRR

### the discount rate at which NPV=0

11

## The IRR decision rule

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Compare the IRR to the cost of borrowing funds to finance the project

- If IRR=>r: accept

12

## NPV vs IRR

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- With straightforward accept/reject decisions, the NPV and IRR will always give identical decisions

- Safer to use NPV rule when comparing or ranking mutually exclusive projects

13

## Other problems with IRR

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- Multiple solutions

- No solution

14

## Using Annuity Tables

### When there is a constant amount each period, we can use an annuity factor instead of applying a separate discount factor each period

15

## Problems with NPV Rule

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- Capital rationing (more projects may pass NPV test than you can fund) -> use profitability ratio

- Indivisible or "lumpy" projects -> compare combinations to maximise NPV

- Projects with different lives -> renew projects until they have common lives using LCM; use annual equivalent method (using annuity factors, convert stream into a constant annual amount)

16