Key Take Aways Financial Accounting

Key Takeaways – Session 7

• Please review formulas for PV.  “regular”, PV annuity and PV perpetuities.
• Also bear in mind FCF (free cash flow) calculation formula (we’ll delve deeper on this after break)

• EBIT*(1-t) + depreciation – CAPEX – investment in WC.

Possible Criteria to be used to choose projects

• ARR (accounting rate of return or book yield)

• Mean net income/average investment.
• Drawbacks: 1) uses accounting numbers, not cash flows and 2) ignores time value of money.

• Payback Period

• Answers the question: “how long does it take me to get my money back?”
• Has a bias for liquidity at the (potential) expense of profitability.
• Used in combination to NPV (profitability or value metric) to make decisions.
• Payback is particularly relevant when liquidity is tight.

• Net Present Value (NPV)

• Discount project’s FCFs using our (firm’s) cost of capital. If NPV negative, reject, as FCFs cannot service required rate of return by our investors.  If zero or positive, accept project.

• Internal Rate of Return (IRR)

• It is the discount rate that makes NPV=0
• We accept projects that have an IRR higher than our cost of capital
• Problems with IRR:

• With particularly high IRRs, it is unreasonable to assume that we can reinvest those cash flows in other projects at the same rate.
• Does not tell us about the scale of the project (it may offer a phenomenal return… on a very small investment).
• Possibility of multiple IRRs.  The metric is useless then.
• Is misleading in mutually exclusive projects.  

• next session we shall see examples of why the last two problems may arise.

Best,

Carmen