Chapters 2&3: Decision Rules Flashcards Preview

ECON3220 Final Exam > Chapters 2&3: Decision Rules > Flashcards

Flashcards in Chapters 2&3: Decision Rules Deck (16):
1

Three processes in any cash-flow analysis

1. Identification
2. Valuation
3. Comparison

2

Conventions in representing cash flows

- 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

- 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

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

Compare the IRR to the cost of borrowing funds to finance the project
- If IRR=>r: accept

12

NPV vs IRR

- 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

- 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

- 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

Annual Equivalent Value

Divide present value by annuity factor at discount rate and number of years of project to convert any given amount or cash flow into an annuity