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Flashcards in Profit Criteria Deck (9):
1

NPV Definition

Expected present value of future cashflows under a contract, discounted at the risk discount rate

2

NPV Advantages

• Economic theory dictate s that investor chooses project with higher NPV
• Can compare projects of different sizes, timings, unequal lives
• Takes into account investment size – absolute amounts of wealth change
• Can handle non-conventional cashflows
• Additive
• Assumes cashflows generated during life of project can be reinvested at rate equal to opp cost of capital - reasonable

3

NPV Disadvantages

• Assumes perfectly free and efficient capital markets
• Assumes discount rate correctly reflects inherent riskiness of product
• Not very simple to present to non-technical people
• By itself tells you very little – needs to be expressed in terms of a ratio to be more meaningful (eg in terms of pv of premium, dist cost/initial commission)

4

IRR Definition

Discount rate that would give a NPV of 0

5

IRR Advantages

• Simple
• Compatible with shareholders saying “we want a return of at least x%”
• No need to formulate discount rate
• Easily comparable with other forms of investment (?)

6

IRR Disadvantages

• May not be unique
• May not exist
• Doesn’t take size of project into account when comparing alternatives
• Difficult to relate to other measures (eg premium income)
• Assumes cashflows generated during life of project can be reinvested at rate equal to IRR. As IRR increases this assumption becomes more unrealistic
• Doesn’t handle non-conventional cashflows well (multiple changes in sign of cashflow)
• Not additive

7

DPP Def

Earliest policy duration at which the accumulated value of profits is 0

8

DPP Advantages

• Useful means of comparing products if capital is a particular problem
• Easy to explain as a breakeven point
• Simple to calculate
• Useful screening device

9

DPP Disadvantages

Often not agree with NPV – ignores cashflows subsequent to the DPP itself