NPV & IRR
Net Present Value (NPV) Applied
1. Identify all outflows/inflows associated with the investment. 2. Determine discount rate appropriate for the investment. 3. Find the PV of the future cash flows. Inflows are +, Outflows are - 4. Compute the sum of all the discounted CFs. 5. Subtract initial cost of the investment from inflows.
Refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Thus it is the ___ needed to make a given investment.
Cost of Capital, RRR
The overall ___ is the weighted average of a company's capital sources, known as the ___.
Cost of Capital, Weighted Average Cost of Capital
IRR Decision Rule
For independent projects, adopt all projects with IRR > required project return. These projects will also add value to the firm.
Firms will often establish a Required Rate of Return (RRR) to determine the minimum acceptable return percentage that the potential investment must earn.
The IRR must be greater than the RRR
IRR and NPV
IRR should always be used in conjunction with NPV for a clearer picture of the value represented by a potential project a firm may undertake.
IRR & Opportunity Cost
If IRR > Opportunity Cost, then NPV > 0.
IRR & Opportunity Cost
If Opportunity Cost = IRR, then NPV is equal to 0.
Depending on the initial costs, a project may have a low ___ but a high NPV, meaning that while the pace at which the company sees returns on that project may be slow, the project may also add overall value to the firm.
Internal Rate of Return
The ___ does provide a meaningful measurement of the absolute growth of a portfolio. And, it is a valuable tool for determining if a portfolio is growing enough to meet a future need or a specific investment goal.
Internal Rate of Return
The ___ rule can be affected by problems of scale and timing of cash flows.
Internal Rate of Return
While __ is a very popular metric in estimating a project's profitability, it can be a misleading tool if used alone.
Internal Rate of Return
__ can be applied to any investment that can be represented as a series of of cash flows
Internal Rate of Return
___ is not an effective measurement tool for analyzing the long term performance of the portfolio's underlying assets or comparing your investment manager to a different investment manager or market index.
Internal Rate of Return
A popular use of ___ is comparing the profitability of establishing new operations with that of expanding existing ones.
Internal Rate of Return (IRR)
A project with a substantially higher ______ value than other available options would still provide a much better chance of growth.
Internal Rate of Return (IRR)
Any project with an/a ___ greater than its cost of capital is a profitable one.
Internal Rate of Return (IRR)
The ___ can be compared against the prevailing rates of return in the securities market.
Internal Rate of Return (IRR)
You can think of this as the rate of growth a project is expected to generate.
Internal Rate of Return (IRR)
By this definition, the ___ of a portfolio can be significantly affected by both the size and timing of any cash contributions or withdrawals.
Internal rate of return
Finding the ___ is equivalent to finding the discount rate that makes the NPV equal to 0.
Internal rate of return
The ___ is a discount rate where the present value of future cash flows of an investment is equal to the cost of the investment.
Internal rate of return
The ___, also commonly referred to as the dollar/money weighted return, is the measurement of a portfolio's actual performance between two dates, including the effects from all cash inflows and outflows.
Internal rate of return
Pooled Internal Rate of Return (PIRR)
Is a method of calculating the overall internal rate of return of several projects by combining their individual cash flows. To calculate this you need to know the cash flows reviewed and timing of these flows.
Net Present Value (NPV)
Is the PV of the expected future cash inflows, minus the PV of initial cost of the investment.
Capital Structure
Is the choice of long term financing for the investments the company wants to make
Working Capital Management
Is the management of the company's short-term assets and liabilities (inventory and money owed to suppliers)
Capital Budgeting
The allocation of funds to relatively long range projects or investments
Internal Rate of Return (IRR)
The discount rate that equates the PV of cash inflows to the PV of cash outflows. The IRR is the discount rate when the NPV = 0.
The ___ more accurately reflects the cost and profitability of a project.
Modified IRR
Assumes that positive cash flows are reinvested at the firm's cost of capital; and initial outlays are financed at the firm's financing cost. By contrast, the IRR assumes CFs from a project are reinvested at the IRR.
Modified Internal Rate of Return (MIRR)
In calculating the ___ of an investment pro-posal, we use an estimate of the opportunity cost of capital as the discount rate.
NPV
The ___ of an investment is the present value of its cash inflows minus the present value of its cash outflows.
NPV
__ represents the expected addition to shareholder wealth from an investment. Maximization of shareholder wealth is the basic financial objective of a company.
NPV
___ describes a way to characterize the value of an investment, and the ___ rule is a method for choosing among alternative investments.
NPV
1. Identify all cash flows associated with the investment—all inflows and outflows.
NPV Procedure
2. Determine the appropriate discount rate or opportunity cost, r, for the invest-ment project.
NPV Procedure
3. Using that discount rate, find the present value of each cash flow. (Inflows have a positive sign and increase NPV; outflows have a negative sign and decrease NPV.)
NPV Procedure
4. Sum all present values. The sum of the present values of all cash flows (inflows and outflows) is the investment's net present value.
NPV Procedure
5. Apply the NPV rule: If the investment's NPV is positive, an investor should undertake it; if the NPV is negative, the investor should not undertake it. If an investor has two candidates for investment but can only invest in one (i.e., mutually exclusive projects), the investor should choose the candidate with the higher positive NPV.
NPV Procedure
NPV Decision Rule
NPV decision rule: for independent projects, adopt all projects with NPV > 0. These projects will increase the value of the firm.
Companies often use the ___ as the appropriate discount rate for capital projects.
WACC
The ___ is a function of a firm's capital structure (common and preferred stock and long-term debt) and the required rates of return for these securities. CFA exam problems will either give the discount rate, or they may give a ___.
WACC
The___ is the alternative return that investors forgo in undertaking the investment.
opportunity cost of capital
Each of the two rules used for making capital-budgeting decisions has its strengths and weaknesses. The NPV rule chooses a project in terms of net dollars or net financial impact on the company, so it can be easier to use when allocating capital.
NPV vs IRR
However, IRR does not assess the financial impact on a firm; it only requires meeting a minimum return rate.
NPV vs IRR
However, the NPV requires an assumed discount rate, and also assumes that this percentage rate will be stable over the life of the project, and that cash inflows can be reinvested at the same discount rate. In the real world, those assumptions can break down, particularly in periods when interest rates are fluctuating.
NPV vs IRR
The appeal of the IRR rule is that a discount rate need not be assumed, as the worthiness of the investment is purely a function of the internal inflows and outflows of that particular investment.
NPV vs IRR
A marginally lower __ spread over a longer time period can be superior to a shorter-term, higher __ investment
Net IRR
Is commonly used in private equity to analyze investment projects that require regular cash investments over time, but offer only a single cash outflow at its completion - an IPO, merger, or acquisition.
Net IRR
It is used in capital budgeting and portfolio management to calculate an investment's yield or overall financial quality by calculating an expected rate of return.
Net IRR
Practically, it is the rate at which the net Present Value of negative cash flow equals the net Present Value of positive cash flow.
Net IRR
The ___ is a modified IRR value that has taken into consideration management fees and any carried interest.
Net IRR
__ is a performance measure equal to the internal rate of return after fees and carried interest are factored in. It is used in capital budgeting and portfolio management to calculate an investment's yield or overall financial quality by calculating an expected rate of return.
Net IRR
Net Internal Rate of Return (Net IRR)
Net IRR is a performance measure equal to the IRR after fees and carried interest are factored in.
Firms use ___ to analyze whether or not to proceed with a project. As long as the ___ is below the rate of return that the company earns by using its capital, it's a good investment.
Cost of Capital
We use an estimate of __ as the discount rate when computing NPV.
Opportunity Cost of Capital
Can be used to find the overall rate of return for an entity running multiple projects or for a portfolio of funds each producing their own rate of return.
Pooled IRR
The ____ can establish the overall IRR for a PE group that has several funds, and is better suited for this purpose than say, the average IRR of the funds.
Pooled IRR
In corporate finance, ____ = ____
RRR, WACC
If the equity investment's market price is lower than the ____ discounted present value, an investor may deem the equity investment worthwhile.
Required Rate of Return
The ___ functions as the discount rate in equity investment valuation; future dividend payments are discounted by an investors ___ to their PV.
Required Rate of Return
Functions as the discount rate in business project evaluation, as future cash flows from a business project are discounted to their present value by a company's ____
Required Rate of Return (RRR)
NPV vs IRR
When NPV and IRR rankings differ, rely on NPV for choosing between or among projects.
NPV equal to 0
When a company undertakes a 0 NPV project, the company becomes larger, but shareholder wealth does not increase.
NPV & IRR
When these two conflict, choose NPV. The NPV represents the expected addition to shareholder wealth from an investment. Maximization of shareholder wealth is the basic financial objective of a company.
Internal Rate of Return (Issue)
When using IRR to compare projects of different lengths, a longer project may have a low IRR, earning returns slowly and steadily, but may add a large amount of value to the firm over time.
Internal Rate of Return (Issue)
When using IRR to compare projects of different lengths, a project of a short duration may have high IRR and low NPV.