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The NPV assumes cash flows are reinvested at the:
A. real rate of return
B. IRR
C. cost of capital
D. NPV
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Why is net present value important to a project?
The net present value of money is a calculation which aims to define today's investment in terms of the value of money in the future. In order to evaluate the sheer financial aspects of a project, sometimes used as a basis upon which to either pursue a project, or drop it, the financial implications may be the deciding factors. The net present value exercise is commonly used simply to show due diligence in evaluating a project. From Wikipedia [edited]: "In finance, the net present value (NPV)of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash flows. In the case when all future cash flows are incoming and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price. NPV is a central tool in discounted cash flow (DCF) analysis, and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting, and widely throughout economics, finance, and accounting."
Should you consider depreciation in NPV?
Net present value calculation only considers the cash amounts and depreciation is not cash amount rather the related assets is counted in for net present value calculation. Depreciation is deducted once from net income to calculate the tax amount but after that it is added back.
Calculate rate of return?
NPV/Initial Cost of Investment
How do you make capital budgeting?
by considering npv analysis , irr and pay back period
How do you value businesses?
Mainly 4 techniques to value businesses # Net Asset Valuation # Dividend Valuation Model # P/E Ratio (Earnings based) # NPV Net asset valuation simply looks at the net assets on the balance sheet of the company being valued. If the company looking to takeover the business is intending to asset strip it then book values are ignored, instead they use realisable values. Otherwise if a going concern, non-monetary items will be valued at replacement costs & monetary items at book values. For any business this valuation should be used to acertain the minimum value to be paid for the business Dividend Valuation Model is based on the equation below P0 = d0(1+g) / (Ke- g) We know that the share price is simply the present value of the future dividend payments discounted at the cost of equity. The above equation simply uses this where d is the dividend paid now, g is growth rate, Ke is cost of equity (i.e. shareholders expectations - required rate of return) The equation can be re written as P0 = d1 / (Ke- g) as a perpetuity of the future income d1 There are some issues with this model # Assumption of a constant dividend each year # Growth rate consistent & constant # Ke assumed not to change P/E Ratio - Earnings based is dependent on the P/E ratio of the business. The P/E ratio of any business signifies 3 things # Status # Prospects # Risk Price/Earning Ratio = Share Price/EPS where EPS is the earning per share EPS = Earnings/number of ordinary shares The model looks at the product of P/E ratio and earnings for the Business to determine its valuation say for example A Co P/E ratio is 15 & are forecasted earnings are £150m then, Value of A is 15*150 = 2250m This really gives us the market capitalisation of the company Issues - Main issue is whether P/E is reliable & accurate. An under performing business with excellent future prospects will be undervalued using this method Net Present Value is the best method for business valuations. This is the present value of future cash flows discounted at the WACC (hence takes into consideration both the cost of equity & debt)
In what sense is a reinvestment rate assumption embodied in the npv irr and mirr methods what is the assumed reinvestment rate of each method?
IRR assumes that all cash flows are reinvested at the project's rate of return, seldom a defensible assumption. Since NPV discounts future cash flows at the investor's cost of capital, it more accurately represents the value of a project. It assumes that cash flows are reinvested at the cost of capital. This is a good assumption so long as the financing can be repaid in stages so as to reduce interest or equity cost. MIRR enables a project to be described with the simplicity of a percentage rate of return, as with IRR, but does not assume that cash flows can be effectively reinvested in the project at the calculated rate of return. Instead, cash flows are assumed to be reinvested at any given rate, such as a bank interest rate.
Why is the IRR not the MIRR the industry standard rate of return?
The IRR assumes all cash flows are reinvested at the IRR. All you need are the property cash flows and the initial outlay to solve the equation. So, it is a simple and objective calculation. For reference, the calculation is as follows: NPV = 0 = CF0/(1+IRR)^0 + CF1/(1+IRR)^1 + ... + CFn/(1+IRR)^n The MIRR assumes that positive cash flows are reinvested at a reinvestment rate. MIRR also assumes that negative cash flows are financed by the company at a finance rate. For reference the calculation is as follows: (( NPV of positive cash flows at reinvestment rate ) / ( NPV of negative cash flows at finance rate ))^(1/(n-1) - 1 This makes MIRR unsuitable as an industry standard. First, different firms have different reinvestment rates and different finance rates. So, MIRR cannot be used to compare investments purchased or sold by different companies. Second, the rates will change over time, thus making it impossible to compare MIRR's at different intervals. MIRR is best used internally by a particular firm choosing between several investments at a given time.
When Projects are mutually exclusive which project should be selected using npv and risk level?
Problems with project ranking: 1. Mutually exclusive projects of unequal size (the size disparity problem) - the NPVdecision may not agree with the IRR or PI. Solution: select the project with the larges NPV (not IRR). 2. The time disparity problem with mutually exclusive projects - NPV and PI assume cash flows are reinvested at the required rate of return for the project. IRR assumes cash flows are reinvested at the IRR. NPV decision may not agree with the IRR. Solution: select the project with the largest NPV. A good method to evaluate and rank project better is to use the Equivalent Annual Annuity (EAA) method. This is like calculating for PMT when doing TVM. It simply means, you will be getting that amount as an inflow each year or period. Therefore, you would want to choose the highest figure.
Does the npv of future cash flows increase or decrease as the discount rate increases?
NPV decreases with increasing discount rates.
When cash flows have been adjusted for inflation but that the discount rates are nominal will this lead to an underestimation of NPV.?
Yes.
IRR VS NPV?
IRR: Internal rate return NPV: Net present value Both are measure of the viability of a project(s) You can have multiple IRR (because of discontinued cash flows) but you always have one NPV.
How does the reinvestment rate assumption affect the NPV versus IRR conflict?
Apparently the NPV and IRR are methods to obtain capital budgets. The reinvestment rate assumption affects both methods because it is what determines now much incoming cash flow is reinvested into project.
What does the term npv stand for?
The most common use of the acronym NPV is to refer to net present value. Net present value is the sum of the present values of individual cash flows of the same entity.
What NPV discounting is?
Npv is the net present value of cash flows.The npv is a method of calculating whether a project is worth while based on its initial investment and the returns that will be received.Cash flows can be considered an amount of money which will flow into or out of the business. In the commercial world we can not just look at the values and assume that the same amount of money you invest in this project can for example be put into a bank and you will have a guaranteed amount of money from this. This is considered to be the time value of money, this is also the reason that we reduce the cash flows to the net present value to give a fair view of the cash flows. The % we can receive from the bank is considered to be the cost of capital e.g 7% So we then use this formulae to calculate the npv So the first cash outflow is not discounted as this is the beginning so technically no money could be invested anywhere. We then take the cash flow from the first year: Cash inflow : £1000 * (100%-7%)
What are the disadvantages of IRR method?
In the IRR method, the intermediate cash inflows are assumed to be consumed and so are not reinvested. The unmodified IRR method, as compared with the NPV method, will not show the superiority of any two mutually exclusive investments with two different initial outlays. In such a case, an investment with lower IRR could have a higher NPV and therefore should be chosen by an investor. In some cases where there are streams of positive and negative cash flows in an investment, the IRR method may yield more than one IRR. This is not a disadvantage if the calculations are performed correctly.
What method of evaluating capital investment proposals uses the concept of present value to compute rate of return?
The method that uses the concept of present value to compute rate of return is called the Net Present Value (NPV) method. In this method, the cash inflows and outflows of a capital investment proposal are discounted to their present value using a discount rate. The NPV is then calculated by subtracting the initial investment from the present value of the cash flows. A positive NPV indicates a profitable investment, while a negative NPV suggests an unprofitable investment.
What reinvestment rate assumptions are implicitly made by the net present value and internal rate of return methods and which method is best?
NPV's assumption is more conservative and realistic. because in order to accept the project, the IRR must be greater than the cost of capital.Both methods assume that a project will cost some money up front, and then produce cash flow returns over a period of time. Both assume that these cash flows will be reinvested by the firm.
