NPV

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1. Net Present PV (future cash flows at investor required rate of return)

(NPV) = minus the initial investment

2. Net Present Val- The difference between an investment's market value and
ue Definition its cost.

3. What is the rule Accept if NPV>0

of NPV? Reject if NPV <0

4. Main advantages Gives a monetary value for the added value created for
of NPV shareholders by the project, over and above their required
return.

Links back to the main purpose of corporate finance

(generating value) and capital budgeting (choosing invest-
ments that generate the most value for a given risk profile).

5. Mutually exclu- A situation where taking one investment prevents taking

sive investments the other.

6. Payback The amount of time required for an investment to generate

cash flows sufficient to recover its initial cost.

7. The payback de- Accept if payback period is less than benchmark

cision Reject payback period is greater than benchmark

8. Discounted pay- The length of time required for an investment's discounted

back cash flows to equal its initial cost

9. Discounted pay- Accept if discounted payback period is less than bench-

back rule mark
Reject if discounted payback period is greater than bench-
mark

10. Advantages of 1) Includes time value of money, (2) Easy to understand,

Discounted Pay- (3) Doesnot accept negative estimated NPV investments,
back Period (4) Biased towards liquidity

11.
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Disadvantages of May reject positive-NPV investments, (2) requires an ar-
Discounted Pay- bitrary cut-off point, (3) ignores cash flows beyond the
back Period cut-off date, (4) biased against long-term projects, such
as research and development, and new projects.

12. Average Ac- An investment's average net income divided by its average
counting Return book value
(AAR)

13. AAR rule Accept if average accounting return is greater than target
return
Reject if average accounting return is less than target
return

14. Advantages of Easy to calculate.

AAR Needed information will usually be available.

15. Disadvantages of 1. Not a true rate of return; time value of good money is
AAR ignored.
2. Uses an arbitrary benchmark cut-off rate.
3. Based on accounting (book) values, not cash flows and
market values

16. Internal Rate of The discount rate that makes the NPV of an investment
Return (IRR) zero

17. IRR Rule Accept if internal rate of return is greater than discount
rate.
Reject if internal rate of return is less than discount rate.

18. Multiple rates of The possibility that more than one discount rate will make
return the NPV of an investment zero.

19. Rule of Thumb The maximum number of IRRs there can be is equal to
the number of times that the cash flows change sign from
positive to negative and/or negative to positive.

20. Advantages of 1. Closely related to NPV, often leading to identical deci-

IRR sions.
2. Easy to understand and communicate.
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21. Disadvantages of 1. May result in multiple answers, or not deal with non-con-
IRR ventional cash flows.
2. May lead to incorrect decisions in comparisons of mu-
tually exclusive investments.

22. The Profitability The present value of an investment's future cash flows di-
Index (PI) vided by its initial cost. It can also be called the benefit-cost
ratio.

23. PI Rule Accept if PI > 1

Reject if PI < 1

24. Advantages of PI 1. Closely related to NPV, generally leading to identical

decisions.
2. Easy to understand and communicate.
3. May be useful when available investment funds are
limited.

25. Disadvantages of May lead to incorrect decisions in comparisons of mutually

PI exclusive investments.

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