Week 9 - Firm Financial Decisions - Investment Decisions 1 Flashcards
(12 cards)
Calculate net present value
→ NPV measures the dollar change in wealth from investing in the project
→ We can define NPV as the present value of the benefits less than the present value of the costs from investing in the project
Two types of decision making:
- The Investment Decision: firms invest in real assets to produce goods and services.
- The Financing Decision: firms pay for these real assets by selling (issuing) financial assets (bonds, shares) which are claims on the cash flows generated by real assets
The investment decision is the most important decision for the following reasons:
→ Long term impact: these decisions involve significant expenditures on long term assets
→ Irreversibility: once made, investment decisions are often difficulty or costly to reverse
→ Strategic Importance: Investment decisions shape the firms’ future. They determine the capacity, capability, and competitive position of the firm in the market
Resource allocation: these decisions involve allocating limited resources amongst competing projects
The key consideration in the investment decision is whether the proposed investment increases the value of the firm
→ The cost of capital is the rate of return that a company needs to earn on its investment projects to maintain its market value and satisfy its investors
→ It is essentially the opportunity cost of using the firm’s capital for a specific project instead of investing it elsewhere with a similar risk profile
It is usually the weighted average of a firm’s cost of debt (e.g bonds) and cost of equity (e.g. shares)
Stand-alone Projects:
→ Projects are stand-alone when their cash flows are unrelated
→ With stand-alone projects, accepting or rejecting one project does not eliminate the other projects from consideration (assuming the firm has unlimited funds to invest) e.g. a company can acquire a competitor and increase its manufacturing capacity at the same time, assuming it has unlimited funds
Mutually Exclusive Projects:
→ Acceptance of one project precludes acceptance of the others
Typically, mutually exclusive projects perform the same function and thus only one project needs to be accepted e.g. a company is considering two possible locations for its new office building
The NPV decision rule (for standalone projects) is:
→ Accept a project if its NPV is positive - because accepting the project increases firm value
Reject a project of its NPV is negative - because accepting it would decrease firm value, whereas rejecting it would cost nothing
Advantages/Disadvantages NPV Rule
Payback Rule
Payback Rule
→ The payback rule: based on the notion that an opportunity that pays back the initial investment quickly is the best idea
→ Accept if the payback period is less than a pre-specified length of time
→ Reject if the payback period is greater than a pre-specified length of time
→ Doesn’t incorporate TVM; simply sums the cash flows and compares them to a cash flow in the present
→ Doesn’t incorporate risk
→ Defined payback period is arbitrary
To apply the payback rule:
1. Calculate the amount of time it takes to pay back the initial investment, called the payback period
2. Accept the project if the payback period is less than a pre-specified length of time - usually a few years
Reject the project if the pay-back period is greater than the pre-specified length of time
Advantages/Disadvantages Pay Back Rule
Internal Rate of Return (IRR)
→ The internal rate of return (IRR) is the discount rate that makes the NPV of the investment project equal to zero
→ Accept a project if the IRR > Cost of Capital
→ Reject a project if the IRR < Cost of Capital
→ In most cases IRR rule agrees with NPV for stand-alone projects if all negative cash flows precede positive cash flows
→ But the decision rule will need to be modified when positive cash flows precede negative cash flows
For projects involving both positive and negative future cash flows, multiple IRRs can exist
Disadvantages/Advantages IRR
