Chapter 8: Net Present Value and Other Investment Criteria

Vocabulary and key investment criteria from Fundamentals of Corporate Finance Chapter 8, covering NPV, IRR, Payback, and Profitability Index.

Net Present Value (NPV)

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

Discounted Cash Flow (DCF) Valuation

The process of valuing an investment by discounting its future cash flows.

NPV Decision Rule

An investment should be accepted if the NPV is greater than $0$ and rejected if the NPV is less than $0$.

The Payback Rule

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

Payback Decision Rule

Accept the project if the payback period is less than some restored benchmark; otherwise, reject it.

Discounted Payback Period

The length of time required for an investment’s discounted cash flows to equal its initial cost.

The Discounted Payback Rule

An investment is acceptable if its discounted payback is less than some pre-specified number of years.

Average Accounting Return (AAR)

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

AAR Decision Rule

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

Internal Rate of Return (IRR)

The discount rate that makes the NPV of an investment zero.

IRR Decision Rule

An investment is acceptable if the IRR exceeds the required return; it should be rejected otherwise.

Mutually Exclusive Investments

A situation in which taking one investment prevents the taking of another.

MIRR: Discounting Approach

A method where all negative cash flows are discounted back to the present at the required return and added to the initial cost before calculating the IRR.

MIRR: Reinvestment Approach

A method where all cash flows (positive and negative) except the first are compounded out to the end of the project’s life to calculate the IRR.

MIRR: Combination Approach

A method where negative cash flows are discounted back to the present and positive cash flows are compounded to the end of the project.

Profitability Index

The present value of an investment’s future cash flows divided by its initial cost; also known as the benefit-cost ratio.