Chapter 8- Net Present Value and Other Investment Criteria

Net present value (NPV)

The difference between an investment’s market value and its cost.

Discounted cash flow (DCF) valuation

(a) Calculating the present value of a future cash flow to determine its value today. (b) The process of valuing an investment by discounting its future cash flows.

Payback period

The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.

Average accounting return (AAR)

An investment’s average net income divided by its average book value.

Average accounting return (AAR) rule

A project is acceptable if its average accounting return exceeds a target average accounting return.

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Internal rate of return (IRR)

The discount rate that makes the net present value of an investment zero.

Net present value profile

A graphical representation of the relationship between an investment’s net present value and various discount rates.

Multiple rates of return

The possibility that more than one discount rate will make the net present value of an investment zero.

Profitability index (PI) (benefit-cost ratio)

The present value of an investment’s future cash flows divided by its initial cost.