Finance 4 Flashcards
what is the internal rate of return, IRR
- the minimum rate of return an investment can generate on its own
- aka, the discount rate at which an NPV calculation = 0
what is the significance of the IRR
- an investment should be accepted if the IRR exceeds the required rate of return
- an investment should be rejected if the IRR is less than the required rate of return
what are the 3 pitfalls with IRR
- having multiple rates of return for one investment
- comparing mutually exclusive investment opportunities
- sometimes it is impossible to determine the IRR
what are the 5 other additional tools that can be useful in the capital budgeting evaluation process
- payback period
- discounted payback period
- profitability index
- economic value added (EVA)
- market value added (MVA)
what is the payback period
- the length of time a project needs to recover an investment
- the time value of money is not considered in this case
- the cut-off period determines if the project should be accepted or rejected
what are the pros of the of the payback period method
- easy to understand
- favors liquidity
- allows efficiency in making decisions
what are the cons of the payback period method
- ignores the time value of money
- ignores cash flows beyond the cut-off date
- biased against long-term projects like R&D
what is the difference between the payback period and discounted payback period method
- the discounted payback period method takes the time value of money into account
- making the method more rigorous
- but it still neglects cash flows after the cut-off date
what is the formula for the profitability index
- profitability index = NPV / initial investment
what is the disadvantage of the profitability index method
- the method breaks down when theres more than one resource to be rationed
what is economic value added
- an estimate of true economic profit
- as it takes into consideration the charges of the capital invested in the firm
what is the formula for economic value added, EVA
- EVA = NOPAT - capital charge
- capital charge = cost of capital * capital employed, C0
what is the significance of the economic value added
- if the return on an investment cant cover the cost of capital, the investment should be rejected
- if the return on an investment can cover the cost of capital, the investment should be accepted
what is market value added, MVA
- an extension of the EVA
- you use all the EVAs calculated over a period of time
- and you discount these future EVAs by the cost of capital to get their PV equivalent
out of all the decision making tools that have been explored, what is the hierarchy
- NPV is always the primary decision making tool
- IRR and the rest are secondary options
