Chapter 8: Net Present value and Other Investment Criteria

The Investment Decision (Capital Budgeting Decision

Analyzing the cash flows necessary in investing (how we get the money, what we invest it in, etc.)

Capital Investment Project

an expenditure made in the hope at generating more cash later (cash is spent on both tangible and intangible objects)

Net Present Value

The difference between a project’s value and a project’s cost

Profitability Index

A measure of project worth, net present value per dollar invested

Opportunity Cost of Capital (aka discount rate)

expected rate of return given up by investing in a project rather than in the capital market

NPV rule

managers increase shareholder’s wealth by accepting projects that are worth more than they cost. So, they should accept all projects with a positive NPV

Internal Rate of Return

The discount rate that gives the project a zero NPV

Pitfalls of IRR (Internal Rate of Return)

1. Mutually Exclusive projects

   1. The IRR can give the wring signal, it is not an indication that NPV is higher for one project or another

   2. Often times it will favor a smaller project or the quicker return, and not show that the NPV is higher

2. Lending or Borrowing

   1. Does not differentiate if yo are lending or borrowing when looking at IRR, 50% IRR when lending is good, you will get more than you give, but borrowing at 50% IRR is bad, that is a 50% interest rate and you will pay back more than you borrowed

3. Multiple Rates of Return