the thory of investment decision Flashcards
(19 cards)
What is sensitivity analysis?
A method that examines how changes in a single variable affect the Net Present Value (NPV), while keeping other variables constant.
What is the main limitation of sensitivity analysis?
It does not consider the interaction between variables.
What is scenario analysis?
A technique that evaluates how NPV changes when several variables are altered simultaneously under different scenarios.
What does break-even analysis determine?
The minimum value (e.g., price or volume) required for the NPV to equal zero.
How is risk incorporated into investment evaluation?
By using probability distributions for possible outcomes and calculating expected values and variability (standard deviation).
What does the standard deviation measure in project evaluation?
The degree of variability or risk in the expected returns.
Q: What is the role of utility theory in investment decisions?
A: It helps assess decisions based on the investor’s subjective satisfaction (utility) rather than just expected financial gain.
Q: What is the difference between a risk-averse and a risk-neutral investor?
A risk-averse investor prefers certainty over higher but riskier returns; a risk-neutral investor only considers expected return.
What is the Net Present Value (NPV)?
NPV is the sum of all future cash flows discounted back to present value minus the initial investment.
If NPV > 0 → the project creates value.
What does the Internal Rate of Return (IRR) represent?
IRR is the discount rate that makes the NPV of a project equal to zero. It reflects the project’s expected return.
What is the required return in investment analysis?
It’s the minimum rate of return that an investor expects, often equal to the project’s cost of capital (like WACC).
What is the decision rule when comparing IRR to required return?
If IRR > required return (cost of capital), the project is accepted → it creates value. If IRR < required return, it’s rejected.
What does the Profitability Index (PI) measure?
PI = Present Value of future cash flows / Initial investment. It shows how much value is created per unit of investment.
What is the difference between NPV and PI?
NPV shows total value created in absolute terms; PI shows value created per unit invested (a ratio).
What is the Payback Period (Simple and Discounted)?
It’s the time needed to recover the initial investment. Discounted Payback adjusts cash flows for the time value of money.
What are hybrid instruments in finance?
Instruments with both debt and equity features (e.g. convertible bonds, preferred shares, mezzanine debt).
Do hybrid instruments benefit from tax shields like debt?
Only if they’re classified as debt for tax purposes (e.g. convertible bonds before conversion). Dividends (like on preferred shares) are not tax-deductible.
What are the components of WACC (Weighted Average Cost of Capital)?
WACC combines the cost of equity, cost of debt (after tax), and cost of hybrid instruments weighted by their market value share.
What are some common risk types in investment projects?
Specific project risk, competitive risk, industry/sector risk, international risk, and macroeconomic (market) risk.
