Net Present Value and Investment Criteria

This set of vocabulary flashcards covers key capital budgeting criteria including Net Present Value, Payback rules, Accounting rates, and Internal Rate of Return metrics.

Capital Budgeting

The process of determining whether a proposed investment or project will be worth more, once it is in place, than it costs; the process of allocating or budgeting capital.

Net Present Value (NPV)

The difference between an investment’s market value and its cost; it measures how much value is created or added today by undertaking an investment.

Discounted Cash Flow (DCF) Valuation

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.

Payback Period Rule

An investment is acceptable if its calculated payback period is less than some prespecified number of years; it is often biased toward shorter-term, liquid investments.

Discounted Payback

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

Average Accounting Return (AAR)

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

Internal Rate of Return (IRR)

The discount rate that makes the $NPV$ of an investment zero; it depends only on the cash flows of a particular investment.

Net Present Value Profile

A graphical representation of the relationship between an investment’s $NPVs$ and various discount rates.

Multiple Rates of Return Problem

The possibility that more than one discount rate will make the $NPV$ of an investment zero, which can occur when cash flows are nonconventional.

Mutually Exclusive Investment Decisions

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

Independent Investments

Two projects are independent if they are not mutually exclusive, meaning the decision to take one does not prevent taking the other.

Financing Type Cash Flows

A situation where a company initially receives cash and later pays it out, resulting in an upward-sloping $NPV$ profile.

Modified Internal Rate of Return (MIRR)

A rate of return calculated after modifying cash flows via discounting, reinvesting, or a combination approach to ensure only one answer results.

Discounting Approach (MIRR Method 1)

A method to calculate $MIRR$ by discounting all negative cash flows back to the present at the required return and adding them to the initial cost.

Reinvestment Approach (MIRR Method 2)

A method to calculate $MIRR$ by compounding all cash flows, except the first, to the end of the project's life.

Combination Approach (MIRR Method 3)

A method to calculate $MIRR$ 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.