Financial management - Lecture three 2023 Update
Advantages of NPV - ANS-NPV converts a project's future cash flows into comparable quantities, i.e. risk-adjusted present values, that can be simply summed. Therefore, it recognises the cost of lending capital (time value of money, compensation for bearing risk). Most importantly, NPV is the increase in the value of firm from the project, which is additive. Limitations of NPV - ANS-NPV depends of forecasted cash flows, however, the future cash flows may be difficult to measure (but applies to all methods) NPV depends on the cost of capital (required rate of return). NPV does not adjust for the dynamics of risk and uncertainty of future cash flows. Internal rate of return (IRR) - ANS-IRR is the rate of return that will be earned if a project is purchased and held for its entire life. Alternatively IRR technique determines the 'discount rate' which will make NPV of the project =0. Advantages of IRR - ANS-Same as NPV, three key elements are included. Expressed as a percentage, easy to understand. Accept investment opportunity offering IRR in excess of its opportunity cost of capital - hurdle rate - required by investors. Disadvantages of IRR - ANS-IRR has at least three problems: -Cannot be used to rank projects (relative vs absolute value) -Multiple IRRs (where with non-conventional cash flows) -Mutually exclusive projects. Two reasons NPV profiles cross- Continues...
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