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27 Cards in this Set
- Front
- Back
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What are the three Capital Budgeting Decision rules?
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- NPV
- IRR - Payback Rule |
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What are three things good decision rules do?
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- Adjust for the time value of money (by using a discount rate)
- Adjust for risk (by asking what rate of return is required for a project of this risk class?) - Identify value creation for the firm |
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Definition of Payback
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The amount of time required for an investment to generate net cash flows sufficient to recover its initial cost (investment)
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What is the Payback Rule?
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Accept the project if the payback period is less than some pre-specified limit
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How do you calculate payback?
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Add together future cash flows, until the sum equals or exceeds original investment.
Find fractions if necessary |
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Advantages of Payback Rule? (x3)
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- Easy to understand
- Adjusts for uncertainty of later cash flows (by ignoring them) - Biased towards liquidity (short-term projects that return cash quickly |
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Disadvantages of Payback rule? (x6)
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- Doesn't adjust for the time value of money (no discount rate)
- Requires an arbitrary cut-off point - Ignores cash flows beyond the cut-off date - Biased against long-term projects (E.g. research, new products) - Does not account for risk of the cash flows (no required return asked for) - Does not provide an indication of value creation (no discounting of future cash flows) |
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Definition of NPV
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Net Present Value
- The present value of the project including all inflows and outflows - The difference between an investment's market value and its initial investment |
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What is the NPV rule?
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Accept the project if the NPV is positive. Reject if negative.
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How do you calculate NPV?
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1. Calculate Present Value of each cash flow
2. Add cash flows together 3. Compare with original cost |
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Advantages of NPV (x3)
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- Adjusts for time value of money (uses discount rate)
- Adjusts for risk (discount rate chosen to reflect the project) - Provides information on value creation (NPV is a direct measure of value/wealth creation) |
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Disadvantages of NPV (x2)
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- Must know cash flows
- Large amount of analysis - possibly high cost |
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Definition of IRR
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-Internal Rate of Return
- The discount rate that makes NPV = 0 - Based on the estimated cash flows and the required rate of return on the project |
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What is the IRR Rule?
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Accept the project if the IRR is greater than required return
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Advantages of IRR (x3)
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- Adjusts for the time value of money (discount rate)
- Adjusts for the risk of the cash flows (comparing IRR to required return) - Value creation is implied (IRR > discount rate) |
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Disadvantages of IRR (x3)
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- Can be misleading/unreliable - multiple or no IRR
- IRR may overstate the 'rate of return' on a project - Value creation is implied, but not the size of the value |
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When do multiple IRR's occur?
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When we do not have a conventional cash flow
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What is a conventional cash flow?
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First cash flow is negative and all following cash flows are positive
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What should we do when we get multiple IRR's?
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Use NPV!
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What is the NPV Profile?
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A graphical representation of the relationship between an investment's NPV and various discount rates
- As discount rates increase, NPV decreases |
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Independent Project
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The decision to accept or reject the project does not affect the decision to accept or reject any other project
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Mutually Exclusive:
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Taking one investment prevents taking the other
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When you have mutually exclusive projects, which one should you take?
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The project with the higher NPV
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When dealing with NPV and IRR, which two conditions must be met:
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- Conventional cash flows
- Projects must be independent |
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What is the order of use of decision rules?
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- IRR (75.6%)
- NPV (74.9%) - Payback Rule (56.7%) |
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Which decision rules are larger firms more likely to use?
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NPV
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Which decision rules are smaller firms more likely to use?
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Any
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