Net Present Value and Other Investment Criteria

These flashcards cover key concepts from the chapter on Net Present Value and Other Investment Criteria, including definitions and important decision rules related to capital budgeting.

Net Present Value (NPV)

Measures how much value is created from undertaking an investment.

Payback Rule

The time it takes to recover the initial cost of a project.

Internal Rate of Return (IRR)

The discount rate that makes the NPV of a project equal to zero.

Profitability Index (PI)

Measures the benefit per unit cost, based on the time value of money.

Average Accounting Return (AAR)

Average net income divided by average book value.

Capital Budgeting

The process of analyzing potential projects for long-term investment.

Decision Rule for NPV

Accept the project if NPV is greater than 0.

Strengths of NPV

Considers all cash flows, time value of money, adjusts for risk.

Weaknesses of Payback Rule

Ignores time value of money and requires an arbitrary cutoff period.

Advantages of IRR

Intuitively appealing; easy to communicate potential value of a project.

Disadvantages of AAR

Not a true rate of return; ignores time value of money.

Mutually Exclusive Projects

Projects where the acceptance of one project precludes the acceptance of another.

Modified Internal Rate of Return (MIRR)

Controls for some problems with IRR and assumes reinvestment at the WACC.

Cash Flows (CFs)

The inflows and outflows of cash expected from an investment.

Time Value of Money (TVM)

The principle that a dollar today is worth more than a dollar in the future.

Accepting the Project

If either NPV > 0 or IRR > required return.