Investment Appraisal I: Basic Techniques

Week 2

What is net present value (NPV)?

the present value of future net cash flows from an investment

What does NPV compare?

The value today of future cash inflows and outflows

What is the NPV decision rule?

Accept if NPV ≥ 0; reject if NPV < 0.

What does it mean when the NPV is greater, equal to or less than zero?

NPV > 0: The project earns more than the required rate of return

NPV = 0: The project earns exactly the required rate of return.

NPV < 0: The project earns less than the required rate of return.

What are mutually exclusive investments?

Projects where choosing one means you cannot choose another.

What is an NPV profile?

A graph showing a projects NPV over a range of discount rates.

What is another name for discount rate when referring to NPV?

cost of capital

What is the IRR?

The discount rate where NPV equals zero.

What does the point where the NPV profile crosses zero represent?

The project’s Internal Rate of Return (IRR).

What does the IRR tell us about the projects cost of capital?

How sensitive NPV is to errors in the estimated cost of capital.

What is the IRR decision rule?

Accept if, IRR ≥ required rate of return.

What is linear interpolation used for?

To estimate the IRR when it is difficult to calculate directly.

Why might finding the IRR manually be difficult?

Because investments may have multiple periods and mixed cash flows

What does linear interpolation assume about the NPV profile?

It assumes a linear relationship between NPV and the discount rate

What does a linear relationship mean?

The NPV profile is treated as a straight line rather than a curve,

What does the linear interpolation estimate?

The IRR by assuming the NPV profile is a straight line.

What information is needed for linear interpolation?

• A discount rate where NPV is positive

• A discount rate where NPV is negative

• The positive NPV

• The negative NPV

What is the IRR formula?

What does linear interpolation of IRR look like on a graph?

How do you improve the accuracy of the estimated IRR linear interpolation?

By reducing the range of the two chosen discount rates

What is the gold standard for evaluating investment opportunities for financial managers?

NPV

Do NPV and IRR decisions always agree?

No, especially when the projects are mutually exclusive

What are the two major problems with IRR?

1. If project cash flows don’t follow conventional patterns, could be no IRR, or multiple IRRs.

2. Compared to NPV, the IRR method relies on flawed reinvestment assumptions.

What is a conventional project cash flow?