Corporate Finance Fundamentals - Week 2

The time it takes for the discounted cash flows from a project to equal the initial investment.

A financial metric that measures the profitability of an investment by dividing average accounting profit by the initial investment.

The average annual accounting profit generated by an investment, divided by the average investment.

The minimum acceptable rate of return required by an investor or company for an investment.

The additional income generated by a new investment.

The difference between the present value of project benefits and costs.

Present value of future cash inflows minus initial investment cost.

Accept projects with a positive NPV and reject those with a negative NPV.

A dollar today is worth more than a dollar in the future.

Accounting profit only shows the profitability, excluding the opportunity cost; Cash flows reflect cash inflows and outflows. NPV calculation must account for Opportunity Cost.

Accept investments with an ARR greater than or equal to the target return, reject otherwise.

The discount rate that makes the NPV of a project equal to zero.

Accept projects with an IRR greater than the cost of capital, reject otherwise.

Accept projects with a positive NPV and reject those with a negative NPV.

Simplicity - Easy to calculate and understand.

Ignores the time value of money and cash flows.

The IRR of a project where the initial cash flow is negative and subsequent cash flows are positive. The decision rule is to accept the project if the IRR is greater than the required rate of return (R).

The IRR of a project where the initial cash flow is positive and subsequent cash flows are negative. The decision rule is to accept the project if the IRR is less than the required rate of return (R).

Projects that are competing for the same resources, and only one can be chosen. You can accept one or reject both, but not accept both.

A project with a mixture of positive and negative cash flows throughout its lifespan.

A situation where a project with mixed cash flows has more than one IRR.

When a project with mixed cash flows has more than one IRR, there is no single valid IRR to use for decision-making.

Even if a project with mixed cash flows has multiple IRRs, the NPV decision rule still applies. If NPV is positive, accept the project; if negative, reject.

The discount rate that makes the Net Present Value (NPV) of an investment equal to zero.

Accept a project if its IRR is greater than the required rate of return (cost of capital). Reject the project if its IRR is less than the required rate of return.

The IRR rule and the NPV rule are equivalent. When a project's IRR is greater than the discount rate, its NPV is positive. When the IRR is less than the discount rate, the NPV is negative.

Using trial and error, find the discount rate that sets the Net Present Value (NPV) of the project's cash flows equal to zero.

If the discount rate you use is less than the IRR, the project will have a positive NPV. If the discount rate is higher than the IRR, the project will have a negative NPV.

The IRR is the rate of return that an investment is expected to yield.

There are some limitations to using IRR. When a project has multiple IRRs, the IRR rule may not be reliable. IRR can also lead to misleading decisions in situations where the required rate of return can vary over the life of the project.

IRR is a widely used tool to evaluate investment proposals. Businesses and investors use it to compare different investment opportunities and make informed decisions.

IRR doesn't consider the size (scale) of investments when comparing projects. A small project might have a higher IRR even with a smaller overall profit, making it seem more appealing than a larger project with a lower IRR but higher potential profit.

A method to address the scale problem in IRR. Calculate the IRR of the difference (increment) between the cash flows of two mutually exclusive projects. This helps determine if the larger project is worth the extra investment.

A process used to compare mutually exclusive projects by analyzing the additional (incremental) cash flows and profitability of the larger project compared to the smaller one.

The present value of the additional cash flows generated by a larger project is greater than the additional investment cost. This indicates the larger project is profitable.

A ratio that measures the value created per dollar invested. Calculated by dividing the present value of future cash flows by the initial investment.

When comparing mutually exclusive projects with PIs greater than 1, use incremental analysis to determine which project generates the most value. This involves calculating the PI of the incremental investments.

PI helps maximize value creation by identifying projects that generate the highest return per unit of investment. This is especially important when comparing mutually exclusive projects.