T6: Investment Decision Rules

Net Present Value (NPV)

The difference between the present value of a project's cash inflows and outflows; the gold standard investment decision rule — accept if positive, reject if negative

Cost of Capital

The discount rate used in NPV calculations; reflects the risk of the specific project, not necessarily the firm's overall rate

Mutually Exclusive Projects

Projects where accepting one means rejecting the others; must be compared using NPV — pick the highest NPV among positive options

Equivalent Annual Annuity (EAA)

Converts a project's NPV into an equivalent fixed annual cash flow; used to compare mutually exclusive projects with different lifespans

Internal Rate of Return (IRR)

The discount rate that makes a project's NPV equal to zero; accept if IRR exceeds the cost of capital for independent projects

IRR vs NPV conflict

When mutually exclusive projects have different NPV and IRR rankings, always follow NPV — IRR ignores the scale of investment

Multiple IRRs

When a project's cash flows change sign more than once, multiple IRRs can exist, making the IRR rule unreliable

Profitability Index (PI)

NPV divided by initial investment; measures value created per dollar invested — used to rank projects under a budget constraint

Payback Period (PP)

The time required to recover the initial investment from cash flows; flawed because it ignores time value of money and cash flows after the cutoff

Reinvestment Assumption

IRR implicitly assumes intermediate cash flows are reinvested at the IRR rate; NPV assumes reinvestment at the cost of capital, which is more realistic

Scale Problem

IRR ignores the size of investment — a high IRR on a small project can look better than a lower IRR on a much larger, more valuable project