Week 4: NPV and Investment Appraisal

Flashcards covering key concepts from the ACFI 103 Introduction to Finance lecture on Net Present Value (NPV) and Investment Appraisal.

What does NPV stand for in finance?

Net Present Value

What is the formula for the present value of a single cash flow?

PV = C * DF, where C is the cash flow and DF is the discount factor.

Define Net Present Value (NPV).

Present value of the cash inflows minus the present value of the cash outflows.

What is the cost of capital?

The required annual rate of return on an investment project; also known as the discount rate, required rate of return, or hurdle rate.

According to the NPV decision rule, when should a project be accepted?

If the NPV is greater than or equal to 0, accepting the project will increase the wealth of the shareholders.

What is a key assumption made about project cash flows when using NPV?

Operating cash flows take place at the end of the period to which they relate.

What are mutually exclusive projects?

Multiple investment projects where the business can only proceed with one.

What is the decision rule for mutually exclusive projects regarding NPV?

Choose the project with the highest NPV.

What is the decision rule for investment timing decisions regarding NPV?

Choose the option with the highest NPV at time 0.

What does EAA represent in the context of annuities and equipment replacement?

The cash flow per period (e.g., per year) which is equivalent to the PV of buying, operating, and selling the equipment.

Give the formula for EAA.

EAA = PV / AF (Annuity Factor)

What does Payback Period (PP) measure?

The time it takes for project cash inflows to equal the initial investment.

What is the decision rule for the Payback Period?

Accept the project if the PP is less than the target PP.

List one issue with using the payback period.

Doesn’t consider the time value of money. Unreliable indicator when choosing between projects. Cash flows after the payback period effectively ignored. Provides no indicator as to the projects worth.

What is discounted payback period?

Time for project PV of cash inflows = initial investment

Define Internal Rate of Return (IRR).

The project's annual rate of return.

What is definition 2 of IRR?

The discount rate at which the project NPV = zero

What is the IRR decision rule?

If IRR > cost of capital : project should be accepted. If IRR < cost of capital : project should be rejected

What is linear interpolation used for in the context of IRR?

Calculating the IRR.

What does capital rationing refer to?

A shortage of funds available for investment projects.

What is the profitability index?

Ensures the best ‘bang for the buck’ when investing. Measures NPV per $ invested

Give the formula for profitability index (PI)

PI = PV of future cash flows / Initial Investment (or Cost)

What does a PI > 0 indicate?

The project is worthwhile