FAI Theory - NPV and Investment Analysis

These flashcards summarize key concepts related to NPV, IRR, economic life, and investment analysis, aiding in exam preparation.

What does NPV stand for?

Net Present Value

What is NPV?

The sum of all cash inflows and outflows discounted at a required rate of return.

What does NPV stand for?

Net Present Value

What is NPV?

The sum of all cash inflows and outflows discounted at a required rate of return.

What happens to NPV when the interest rate increases?

The NPV decreases, meaning the present value of future inflows is lower.

When the interest rate decreases, what happens to the discounted value of future cash flows?

It increases, meaning the present value of future inflows is higher.

What is the relationship between NPV and economic life of a project?

A project’s economic life is the term that maximizes the NPV.

What does the NPV method assume about cash flow reinvestment?

It assumes cash flows are reinvested at the cost of capital.

What should be used if NPV profiles cross?

The MIRR (Modified Internal Rate of Return) method.

How does initial investment affect NPV?

Higher initial costs reduce NPV.

What impact does a higher discount rate have on NPV?

It lowers NPV.

How do larger and earlier cash flows affect NPV?

They increase NPV.

What effect does a longer project life have on NPV?

It may generate higher NPV but with greater risk.

How do risk and uncertainty impact NPV?

More risk reduces expected NPV.

What is the effect of higher taxes on NPV?

They reduce after-tax cash flows, decreasing NPV.

How does inflation affect cash flows?

It affects the real value of cash flows.

What is IRR?

Internal Rate of Return, the discount rate at which NPV becomes zero.

What should be done if the IRR is below the cost of capital?

The investment should not be realized.

What does IRR assume about cash flow reinvestment?

It assumes cash flows are reinvested at the IRR.

What is the implication if IRR is greater than the cost of capital?

The investment should be realized.

What can cause multiple results for the IRR?

If a project has non-normal cash flows.

What factors affect IRR?

Cash flow size & timing, project duration, investment cost, reinvestment rate assumption, risk profile.

What is common life?

The standard time horizon used for comparing projects with different durations.

How does project duration affect common life?

Projects with different lifespans need adjustments for comparison.

What is cash flow?

Money moving in and out of an investment.

What factors affect cash flow?

Revenue & sales growth, operating costs, working capital changes, depreciation & tax effects, capital expenditure.

What does MIRR assume about cash flows?

It assumes cash flows are reinvested at the cost of capital.

What does EVA stand for?

Economic Value Added.

What are normal cash flows?

Cash flows with only one change in sign, resulting in one IRR.

What are non-normal cash flows?

Cash flows with multiple changes in sign.

What should an economic life analysis focus on?

Maximizing the NPV.

What is the relationship between interest rates and investment?

Interest rates affect borrowing costs, discounting, and investment decisions.

What is an annuity?

A series of equal cash flows over time.

How does the interest rate affect the value of an annuity?

Higher rates decrease the present value of annuities.

What effect does a longer annuity period have?

It increases total payout.

How does inflation affect annuities?

It reduces the purchasing power of future payments.

What is the growth rate's impact on annuities?

Increasing annuities provide better future cash flow.

What is the goal of economic life and NPV analysis?

To maximize NPV by choosing the number of years where the asset provides the highest net benefits.

What distinguishes an ordinary annuity from an annuity due?

An ordinary annuity is paid at the end of a period, while an annuity due is paid at the beginning.

How does income affect cash flow?

Higher revenue improves cash flow.

What role does operating cost play in cash flow?

Higher operating costs reduce cash flow.

How do working capital changes impact cash flow?

Increased inventory or receivables lower cash flow.

What is the impact of depreciation on cash flow?

Non-cash charges like depreciation impact reported cash flow.

How do large capital expenditures affect free cash flow?

They reduce free cash flow.

What should a project’s economic life analysis consider?

High resale values.

What is a critical factor for determining cash flow timing?

Timing and amount of cash flows.

What is the effect of project duration on IRR?

Shorter projects with high early returns increase IRR.