Profit Criteria Flashcards Preview

CA1 > Profit Criteria > Flashcards

Flashcards in Profit Criteria Deck (9):

NPV Definition

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


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


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)


IRR Definition

Discount rate that would give a NPV of 0


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 (?)


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



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


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


DPP Disadvantages

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