Lecture 8 Capital Investment Decisions Flashcards
(13 cards)
What does the time value of money imply regarding £100 today compared to £100 next year?
£100 today is preferred due to:
* Opportunity cost - can invest earlier
* Risk and uncertainty - future payments are less certain
* Inflation - money loses purchasing power
The time value of money concept highlights that money available now is worth more than the same amount in the future due to potential earning capacity.
What is Net Present Value (NPV)?
NPV uses relevant cash flows only, discounted using cost of capital, assuming investment occurs immediately.
NPV is a key financial metric used to evaluate the profitability of an investment.
What is the formula for calculating NPV?
NPV = sum of (CFn)/(1+r)^n - Initial investment
where r is the discount rate.
CFn represents cash flows in each period, and ‘n’ is the time period.
What is the decision rule for NPV?
Accept if NPV > 0 and choose the project with the highest NPV.
This rule helps in identifying profitable investments.
What are the advantages of using NPV?
- Based on cash flows
- Considers time value of money
- Directly measures value added
- Works for projects of all sizes
These advantages make NPV a preferred method for evaluating investment opportunities.
What are the disadvantages of using NPV?
- Requires discount rate
- May not consider non-financial factors
These limitations can affect the comprehensiveness of the NPV analysis.
What is the profitability index?
Profitability index = NPV of project / investment required.
This ratio provides a relative measure of profitability for different investments.
What is the Internal Rate of Return (IRR)?
The discount rate where NPV = 0, representing the project’s actual rate of return.
IRR is used to evaluate the attractiveness of a project or investment.
How is IRR calculated?
Method: use trial and error, or interpolate between two rates.
This approach helps in finding the precise rate at which the NPV becomes zero.
What is the decision rule for IRR?
Accept if IRR > Cost of Capital.
This rule helps in determining whether the investment meets the minimum required return.
What are the advantages of using IRR?
- Easy to compare with cost of capital
- Widely used
These advantages contribute to IRR’s popularity among financial analysts.
What are the disadvantages of using IRR?
- Can produce multiple IRs
- May give incorrect ranking for non-normal cash flows
- Doesn’t consider absolute size of returns
These issues can complicate the decision-making process when using IRR.
NPV vs IRR
