Topic 5: Investment Decision Rules

Question 1

When is a stand-alone project worth making?

Answer 1

If the NPV is positive

Question 2

In Stand-Alone projects if investment rules conflict…. What should you do?

Answer 2

Follow the NPV decision rule

Question 3

What is the Internal Rate of Return (IRR) Investment Rule?

Answer 3

Take any investment where the IRR exceeds the cost of capital. Turn down any investment whose IRR is less than the cost of capital

Question 4

In which situations will the IRR rule and NPV rule conflict?

Answer 4

• Delayed Investments
• Nonexistent IRR
• Multiple IRRs

Question 5

What does IRR measure?

Answer 5

The average return of the investment and the sensitivity of the NPV to any estimation error in the cost of capital

Question 6

What is the payback period?

Answer 6

The amount of time it takes to recover or pay back the initial investment

Question 7

What is the Payback Rule?

Answer 7

If the payback period is less than a pre-specified length of time, you accept the project. Otherwise, you reject the project.

Question 8

What are the Disadvantages of the Payback Rule?

Answer 8

• Ignores the project’s cost of capital and time value of money
• Ignores cash flows after the payback period
• Relies on an ad hoc decision criterion about the cutoff period
• A project accepted based on the payback criteria may not have a positive NPV

Question 9

What are the advantages of the Payback Rule?

Answer 9

• Easy to understand and apply
• Focuses on the liquidity of an investment project
• Commonly used when the capital investment is small and for minor decisions with short horizons

Question 10

When you must choose only one project among several possible projects, the choice is….

Answer 10

Mutually exclusive

Question 11

Simplify NPV Rule

Answer 11

Select the project with the highest NPV

Question 12

Whats wrong with selecting the project with the highest IRR?

Answer 12

It may lead to mistakes when the projects differ in:

• Scale of investment
• Timing of cash flows
• Riskines

Question 13

Explain the mistake with IRR rule in terms of Scale of Investment?

Answer 13

• If a project’s size is doubled, its NPV will double
• This is not the case with IRR
• Thus, the IRR rule cannot be used to compare projects of different scales

Question 14

Explain the mistake with IRR rule in terms of Timing of cash flows?

Answer 14

• The IRR can be affected by changing the timing of the cash flows, even when the scale is the same
• IRR is a return, but the dollar value of earning a given return depends on how long the return is earned

Question 15

Explain the mistake with IRR rule in terms of Riskines?

Answer 15

• An IRR that is attractive for a safe project need not be attractive for a riskier project
• A higher IRR is necessary to make the project attractive

Question 16

What is the Profitability Index formula?

Answer 16

Question 17

What is the Profitability Index rule?

Answer 17

Take the projects with the highest PIs, provided PI > 0

Question 18

What is the shortcomings of the Profitability Index?

Answer 18

• The set of projects taken following the PI ranking exhausts all the available resources
• With multiple resource constraints, the PI can break down completely