Dorene Dang

AFM271
Wednesday May 16 2012

Lecture Five: Investment Decision Rules

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a good evaluation method should:

o consider all cash flows
o account for timing differences
100 today isnt 100 next year
o provide unambiguous decision rule
yes or no no maybe
o measure wealth created for shareholders
ultimately what were seeking to do
if NPV is greater than 0, positives outweigh zero take investment opportunity
o process not perfect: inherent forecasting error when calculating NPV
it does take into consideration timing of cash flows and amount of cash
flows, however, still estimations
o RRR: required rate of return
reflects riskiness of opportunity
next best opportunity could generate __% of cash flow, so we should
pick the opportunity if it generates more
Net Present Value:

sensitivity: what if a certain number changes and see how the NPT or final result gets
affected
o disadvantage with NPV: doesnt tell you the time it takes to generate the cash
flow (3 years? 10 years? 30 years?)
Payback Rule: gives you the time required for an investment to recover its cost
o most firms, cash is scarce: you cannot implement all the projects you want
pick and choose
Payback will tell you when youll get your money back to use in the next
investment opportunity
problem: doesnt consider all the cash flows and no consideration of the
time value of money
you can use a discounted payback rule to consider the time value
of money

Dorene Dang
AFM271
Wednesday May 16 2012

reality is we may not have considered all the cash flows

doesnt give us a clear cut decision: How long is it acceptable
for our capital to be tied up?
o if you use that with NPV, you give your decision maker a
time value aids in a more informed decision
profitability index: benefit / cost ratio
o taking present value of all positive cash flows divided by the present value of all
the investments
o if that ratio = 1, both are equal project breaks even
if 0=NPV PI = 1
1> NPV PI > 1
o used because gives you how much it is profitable in proportion to your
investments
I made $100 000 in the market this year.but I had $10 trillion to work
with
relativity and level are important
o adv: reflects time value of money, considers all cash flows
o disadv: mutually exclusive ignores scale, can be hard to estimate discount rate
internal rate of return (IRR):
o at what discount rate does the project break even?
o set NPV of a project = 0
o maintain all other cash flows
solve for r
o IRR > RRR = Invest
o some project have no IRR (slide 31)

back loaded cash flows: unreasonably cash flow mostly at the end
o opposite would be front loaded (most cash flow at the start, small amount at the
end)

Dorene Dang
AFM271
Wednesday May 16 2012