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CFI Assignment For Week 4

The document explains key financial concepts including Net Present Value (NPV), Internal Rate of Return (IRR), and payback periods. NPV assesses the value created by a project, while IRR is the discount rate that makes NPV zero, with challenges in its calculation. Payback period measures the time to recover initial investment but neglects the time value of money and future cash flows, while the discounted payback period addresses some of these issues but still overlooks cash flows beyond a certain point.

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Turi Flóra
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51 views2 pages

CFI Assignment For Week 4

The document explains key financial concepts including Net Present Value (NPV), Internal Rate of Return (IRR), and payback periods. NPV assesses the value created by a project, while IRR is the discount rate that makes NPV zero, with challenges in its calculation. Payback period measures the time to recover initial investment but neglects the time value of money and future cash flows, while the discounted payback period addresses some of these issues but still overlooks cash flows beyond a certain point.

Uploaded by

Turi Flóra
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

Assignment for the 4th week

1. Explain the concept of Net Present Value rule.


a. If your future cash flows are fixed, how can your NPV change over time?

The net present value tells us how much value is created if the project is accepted.
The present value of an investment’s annual free cash flows less the investment’s
initial outlay.

The net present value rule is the idea that company managers and investors should
only invest in projects or engage in transactions that have a positive net present
value. (Or if NPV=0)

Future cash flows are reduced by the discount rate, so the higher the discount rate
the lower the present value of the future cash flows. A lower discount rate leads to
a higher present value. The higher the net cash flows generated by a company over
time, the higher the NPV of those cash flows will be.

2. Define IRR. (Internal Rate of Return)

The rate of return that a project earns. Defined as the discount rate that equates the
present value of a project’s free cash flows with the project’s initial cash outlay.

The IRR is the discount rate at which the net present value is 0.

1. You can apply for a bank loan at an IRR=5%. The average required return on
bank loans at the market is 4.5%. Would you apply for the former
construction?

Yes, because a project is accepted when the IRR has a bigger (or the same)
value as the required rate of return. In this case it means that the net
present value is positive.

2. List the difficulties of IRR calculation.

Problem 1: There are some cases where because of the cash flow pattern
that the calculation of IRR ends up giving multiple rates. So instead of having
one IRR, we would then have multiple IRR’s. Sometimes the IRR number can
even go in the negative indicating that the firm is actually losing value.

Problem 2: We must only invest if the IRR is greater than the opportunity
cost of capital. But here we have only one opportunity cost of capital. Time
value of money tells us that there are in fact several opportunity costs of
capital, changing each year because of the effect of increasing number of
years.
3. Define the payback period, the discounted payback period. What are the
shortcomings of the methods?

a) Payback period is the number of years needed to recover the initial


cash outlay related to an investment. It tells us how long it takes to
get our money back.

One of the disadvantages is that it doesn’t take into consideration the


time value of money. This method doesn’t consider the fact that a
dollar today is way more valuable than a dollar promised in the
future. The method additionally ignores the inflow of cash after the
payback period.

b) Discounted payback period is the number of years needed to recover


the initial cash outlay from the discounted free cash flows.

The primary disadvantage to using the discounted payback method is


that it ignores all cash flows that occur after the cutoff date. Thus, it
cannot tell a corporate manager or investor how the investment will
perform afterward and how much value it will add in total.

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