Net Present Value and Other Investment Rules
15 important questions on Net Present Value and Other Investment Rules
What is the net present value?
What are the advantages of NPV?
2. NPV is calculated based on all cash flows of a project
3. NPV discounts cash flows properly
What are the disadvantages of NPV?
2. NPV assumes that project is performed as proposed in period 0
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What are the 3 possible future events that affect NPV?
2. Project can be terminated
3. Project's cash flows could become more valuable over time
What are the 6 ways to value investment projects?
2. Discounted payback period
3. Average Accounting Return
4. Internal Rate of Return
5. Profitability index
6. NPV
What is the payback period method?
A:
- simple to implement
D:
- Future cash flows are not discounted
- Cash flows after payback period are not taken into account
- Difficult to compare companies
What is the AAR method?
D:
- Makes use of average book values, not of cash flows
- Time value of money is not taken into account, future profits are not discounted
What is the IRR method?
- Financing project (money is received first): accept project if IRR is smaller than discount rate
- Investment project (company pays first): accept project IRR is larger than discount rate
What is the profitability index method?
What are incremental cash flows?
What are the 4 pitfalls in determining the incremental cash flows?
2. Opportunity costs, costs someone sacrifices by choosing something over something else
3. Side effects, project can increase turnover of a company or decrease it
4. Allocated costs, sometimes costs are related to more than one project
What are the 4 ways to determine the operating cash flow?
2. Bottom-up approach: indirect method, start with net income and add non-cash items like depreciation. = net income + depreciation
3. Top-down approach: sales - costs - tax
4. Tax-shield approach: (sales-costs) x (1-tax rate) + depreciation x tax rate
What are the 4 types of NPV analyses?
2. Scenario analysis - investigation of which variable has the largest effect on the outcome
3. Simulation analysis - tries to take all uncertainty and changing variables into account. Realistic, but also quite complicated
4. Break-even analysis - determines how many products a company should sell to have equal revenues and costs
What is the difference between the accounting and financial breakeven point?
- The accounting point does not take taxes into account, the financial one does.
- Financial is more realistic
What is the Monte Carlo simulation?
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