Podcast
Questions and Answers
What does NPV stand for and why is it important in corporate finance?
What does NPV stand for and why is it important in corporate finance?
NPV stands for Net Present Value, and it is important because it helps assess the profitability of an investment by calculating the difference between the present value of cash inflows and outflows.
In the example provided, what was the NPV of Alpha Corporation's project that cost £100 and returns £107 in one year with a 6% discount rate?
In the example provided, what was the NPV of Alpha Corporation's project that cost £100 and returns £107 in one year with a 6% discount rate?
The NPV of Alpha Corporation's project was £0.94.
What is the relationship between accounting profit and opportunity cost as demonstrated in the example?
What is the relationship between accounting profit and opportunity cost as demonstrated in the example?
The accounting profit was £7, while the profit considering opportunity cost was £0.97, indicating the impact of the time value of money on profits.
List two alternative investment evaluation methods mentioned in the lecture overview besides NPV.
List two alternative investment evaluation methods mentioned in the lecture overview besides NPV.
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Explain the concept of 'Present Value' in the context of the NPV decision rule.
Explain the concept of 'Present Value' in the context of the NPV decision rule.
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How is Net Present Value (NPV) calculated?
How is Net Present Value (NPV) calculated?
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What does an NPV greater than zero indicate in investment decision-making?
What does an NPV greater than zero indicate in investment decision-making?
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Discuss one key strength of using NPV over other investment approaches.
Discuss one key strength of using NPV over other investment approaches.
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What is the Payback Period (PP) and how is it used in investment decisions?
What is the Payback Period (PP) and how is it used in investment decisions?
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Calculate the payback period given an initial investment of -£5000 and accumulated cash flows of £5550 after 3 years.
Calculate the payback period given an initial investment of -£5000 and accumulated cash flows of £5550 after 3 years.
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Study Notes
Corporate Finance Fundamentals - Week 2
- Topic: Net Present Value (NPV) and Other Investment Rules
- Course: BSP050
- Lecturer: Dr. Kai Hong Tee
- University: Loughborough University
- Office Hours: Tuesdays, 11 am to 1 pm. Email [email protected] to arrange a meeting time.
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Last Week's Lecture Topics:
- Introduction to Corporate Finance functions (Investment, financing, short-term decisions)
- Accounting profit and cash flows
- Opportunity costs and cash flows
- Value of cash flows: Present and future values
Overview of Today's Lecture
-
Methods discussed:
- Net Present Value (NPV)
- Payback Period Method
- Discounted Payback Period
- Average Accounting Return (ARR) method
- Internal Rate of Return (IRR)
- Profitability Index (PI)
Net Present Value (NPV)
- Definition: The difference between the present value of a project's benefits and costs.
- Formula: NPV = PV(Benefits) - PV (Costs)
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Investment Rule:
- Accept if NPV > 0
- Reject if NPV < 0
Example 6.1
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Scenario: Alpha Corporation considering a riskless project.
- Cost: £100
- Future cash flow: £107 one year later
- Discount rate: 6 percent
- NPV Calculation: £.94 = -£100 + £107/1.06
Interpretation of Example 6.1
- Accounting profit: £7 (£107 - £100)
- Profit considering opportunity cost: £0.97 (reflecting positive NPV)
Payback Period (PP)
- Definition: The time it takes for cash inflows to recover the initial investment.
- Investment Rule: Accept if payback period is less than or equal to a specified cut-off time.
Discounted Payback Period
- Definition: Similar to the payback period but uses discounted cash flows.
- Investment Rule: Accept if discounted payback period is less than a specified cut-off time.
Average Accounting Return (ARR)
- Formula: (Average accounting profit) / (Investment)
- Investment Rule: Accept if ARR > target return.
Internal Rate of Return (IRR)
- Definition: The discount rate that makes the NPV of a project equal to zero.
- Investment Rule: Accept if IRR > discount rate; reject if IRR < discount rate.
- Problems with IRR: IRR may not accurately assess mutually exclusive projects.
Profitability Index (PI)
- Formula: PV of future cash flows / Initial investment
- Investment Rule: Accept if PI > 1; reject if PI < 1
Other Important Definitions
- Mutually Exclusive Projects: Projects where the acceptance of one automatically excludes the acceptance of others.
Problems with IRR
- Multiple IRRs: Some projects can have multiple IRRs.
- Scale Problem: IRR ignores project size.
- Non-conventional cash flows: Projects with unconventional cash flow patterns can have multiple or no IRRs.
- Choosing between investments: NPV is preferred when making decisions between mutually exclusive projects.
Incremental Analysis
- Used to compare mutually-exclusive investments: Compares the extra cash flows for each choice to see which decision creates the greatest benefit.
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