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investment decision rules (decision tools (detail explanation) (NPV (NCF…
investment decision rules
decision tools (detail explanation)
NPV
difference between an investment's market value (through discounting its future cash flow, in today's dollars) and its cost (initial cash outlay, in today's dollars)
Net profit at present or the created value
difference between the PV of the
net cash flow (NCF) :warning:
from an investment, discounted at the required rate of return, and the initial investment outlay
NCF
cash inflows
sales of goods and services
sale of physical assets (depreciation)
cash outflows
expenditure on materials, labour
indirect expenses for manufactouring
selling and administrative
inventory and taxes
NPV > 0 --> accept. Vice versa. :red_flag:
magnitude of NPV depends on
value of all the cash flow
required rate of return (or the discounting rate)
Payback period
the amount of time need to pay back the initial investmnet
if the payback period is less than the project life, we accept
But the time value of money isn't incurred into consideration
IRR (internal rate of return)
compare the IRR with the cost of capital of project
IRR is the rate of return to make NPV = 0
IRR RULE: IRR > COST OF CAPITAL, then undertake the investment :warning:
:warning:the IRR RULE will be always valid only when all negative cash flow is before (precede) its positive cash flows. :red_flag: --> for downward sloping with only one solution
situations when IRR rule is wrong :star:
delayed investment
nonexistent IRR
Multiple IRRS
the best method to judge:
clarify the pattern of the curve
upward/downward sloping
quadratic function or others
use the NPV to check
why still use IRR?
IRR measures the average return of the investment
Profitability index (PI)
= NPV / Resource Consumed
assess the profit-to-investment ratio
the resource can be anything - money, resources (like manufacturing space), etc
if more than one resource is included in consideration, the analysis will be broken into different parts
choosing between projects
mutually exclusive projects
highest NPV
highest IRR (wrong when comparing projects of different scales)
Incremental IRR Rule
the difference of cash flow between two mutually exclusive projects
the annual growth rate, cost of capital and live of two projects assumed to be the same
when Incremental IRR = 0, two project have no difference