1
What is the main purpose of investment evaluation methods?
The main purpose of investment evaluation methods is to help decision makers evaluate whether an individual investment should be undertaken and to choose among alternative investments by analysing their benefits and costs through cash flows.
2
Which basic methods are used in the evaluation of investment projects?
The basic methods used in the evaluation of investment projects are net present value, profitability index, internal rate of return, modified internal rate of return, payback period, and discounted payback period.
3
What is the difference between independent and mutually exclusive investment projects?
Independent investment projects are projects whose acceptance or rejection does not affect other projects. Mutually exclusive investment projects are projects where accepting one requires rejecting the others.
4
Why are future cash flows discounted in investment evaluation?
Future cash flows are discounted because cash flows occur over time and must be converted into present values in order to be compared with present cash flows. This makes investment evaluation consistent with the time value of money.
5
What is net present value?
Net present value is the difference between the present values of all benefits and costs of an investment project. It is found by summing discounted cash flows, including the initial cost.
6
What is the decision rule for net present value?
If net present value is greater than or equal to the minimum acceptable level, usually zero, the project is feasible and can be accepted. If net present value is below that level, the project should be rejected.
7
How are mutually exclusive projects compared by using NPV?
When projects are mutually exclusive, the project with the highest non-negative net present value is preferred because it creates the highest net value for the investor.
8
What is net present value ratio?
Net present value ratio is the ratio of an investment’s net present value to the absolute value of its initial cost. It shows the level of net value created per unit of investment cost.
9
What does a positive or negative net present value ratio indicate?
A positive net present value ratio indicates that the investment’s net present value is positive, while a negative ratio indicates that the net present value is negative.
10
What is the profitability index?
The profitability index is the ratio of the present value of an investment’s future cash flows to the absolute value of its initial cost. It measures the present value created per unit of initial investment cost.
11
How is profitability index related to net present value ratio?
Profitability index is equal to one plus the net present value ratio. This means the two measures are directly related and both are based on the investment’s present value and initial cost.
12
What is the decision rule for profitability index?
If the profitability index is greater than one, the investment is considered viable. If it is equal to one, the investor is indifferent. If it is less than one, the investment is considered non-viable.
13
Why may NPV and profitability index produce conflicting rankings?
NPV and profitability index may produce conflicting rankings because profitability index is a relative measure based on the relationship between present value and initial cost, while NPV is an absolute measure. Therefore, scale differences can create ranking conflicts.
14
What is the internal rate of return?
Internal rate of return is the discount rate that makes the net present value of an investment equal to zero. It is interpreted as the investment’s rate of return.
15
Why can IRR become unreliable in some cases?
IRR can become unreliable because investment cash flows may create nonlinear equations with no solution, multiple solutions, or non-conventional cash flow patterns. In such cases, IRR may not provide a reliable evaluation criterion.
16
What is the decision rule for internal rate of return?
An investment is accepted if its internal rate of return is greater than the cost of capital. It is rejected if its internal rate of return is less than the cost of capital.
17
What is the modified internal rate of return?
Modified internal rate of return is the rate that equates the terminal value of the initial investment cost to the sum of the terminal values of the project’s cash flows compounded at the cost of capital.
18
What is the main advantage of MIRR over IRR?
The main advantage of MIRR over IRR is that MIRR uses the cost of capital or another chosen reinvestment rate instead of assuming reinvestment at the project’s IRR. It is also easier to calculate and provides a unique value.
19
What is the payback period?
The payback period is the earliest period in which the cumulative sum of cash flows, including the initial investment cost, becomes zero or positive and remains non-negative afterwards. It shows how long it takes to recover the initial investment.
20
Why can different investment evaluation methods produce different results?
Different investment evaluation methods can produce different results because they focus on different attributes of an investment’s cash flows. Some methods emphasize scale, some emphasize return rate, and others emphasize timing and liquidity, so their rankings may conflict.