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investment decision, theory - Coggle Diagram

- - - - Capital budgeting techniques should allow the firm to select projects that will enhance owner wealth.
      - Relevant cash flows must be analysed to assess whether a project is acceptable.
      - Capital expenditures can be very large and have a significant impact on the financial performance of the firm, great importance is placed on project selection.
  - - - Payback period
      - Discounted payback period
      - Net present value
      - Internal rate of return
  - - - Represents the number of years required for a firm to recover its initial investment in a project.
      - When exactly do we get our money back, when does our project break even.
      - Projects with payback periods shorter than the firm’s maximum payback period are accepted.
    - - Payback period with equal annual cashflows
        
        Payback period =
        
        Example:
        
        If $2m is invested to earn $500,000 per annum for 7 years, what is the payback period?
      - Calculating Payback
  - - - Discount the cash flows before calculate the payback period.
      - Find the present value for the cash flow.
      - PVn = FVn x PVIFr,n
        
        where PV = present value
        
        FV = future value
        
        PVIF = present value interest factor
        
        =
        
        r = required rate of return
        
        n = time period
  - - - NPV = PV of inflows – Cost
        
        = Net gain in wealth
      - If projects are independent, accept if the project NPV > 0.
      - If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value.
  - - - IRR is the amount of profit you get by investing in a certain project.
      - It is a percentage.
      - IRR is the discount rate that equates the present value of net cash inflows with the project’s initial investment, giving an NPV equal to zero.
      - A project is considered acceptable when its IRR is greater than cost of capital.
    - - How to calculate IRR?
        
        Step 1: Using trial and error method.
        
        Step 2: Using IRR formula
        
        IRR =
        
        Where, A = lower discount rate
        
        B = higher discount rate
        
        NPVA= NPV at rate A
        
        NPVB= NPV at rate B
      - IRR (Cont’d)
  - - - Finance theory says to accept all positive NPV projects.
        
        Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects:
        
        An increasing marginal cost of capital.
        
        Capital rationing
    - - Externally raised capital can have large flotation costs, which increase the cost of capital.
        
        Investors often perceive large capital budgets as being risky, which drives up the cost of capital.
        
        If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital.
    - - Reason: Companies believe that the project’s managers forecast unreasonably high cash flow estimates, so companies “filter” out the worst projects by limiting the total amount of projects that can be accepted.
      - Solution: Implement a post-audit process and tie the managers’ compensation to the subsequent performance of the project.
      - The company needs a method of "ranking" the acceptable projects in order to allocate the funds available most beneficially.
      - The profitability index, or PI, method compares the present value of future cash inflows with the initial investment on a relative basis. Therefore, the PI is the ratio of the present value of cash flows (PV) to the initial investment of the project.
      - In this method, a project with a PI greater than 1 is accepted, but a project is rejected when its PI is less than 1.
        Note that the PI method is closely related to the NPV approach. In fact, if the net present value of a project is positive, the PI will be greater than 1. On the other hand, if the net present value is negative, the project will have a PI of less than 1.
- - - - SUPER IMPORTAND