Net Present Value and other Investment Criteria
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| NPV - Investment Rule | Accept project if NPV is +ve. For mutually exclusive projects, choose the one with the highest (+ve) NPV.
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| NPV - Comments | Gold standard of investment criteria. Only criterion consistent w. maximising the value of the firm. Provides proper rule for choosing amoung mutually exclusive investments. Only pitfall involves capital rationing - one cannot accept all + NPV projects.
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| IRR Definition | The discount rate at which project NPV = 0
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| IRR - Investment Rule | Accept project if IRR is greater than opportunity cost of capital.
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| IRR - Comments | Same accept-reject decision as NPV in the absence of project interactions. Pifalls = IRR cannot rank mutually exclusive projects (project w. higher IRR may have lower NPV) & the IRR rule cannot be used with multiple IRRs or an upwards sloping NPV profile.
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| Payback period Definition | Time until the sum of project cash flows = the initial investment
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| Payback - Investment Rule | Accept project if payback period is less than some specified number of years.
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| Payback - Comments | A quick and dirty rule of thumb, with several critical pitfalls. Ignores cash flows beyond the acceptable payback period. Ignores discounting. Tends to improperly reject long-lived projects.
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| Profitability Index Definition | Ratio of NPV to initial investment
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| Profitability Index - Investment Rule | Accept project if profitability index is greater than 0. In case of capital rationing, accept projects with highest profitability index.
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| Profitability Index - Comments | Results in same accept-reject decision as NPV in the absence of project interactions. Useful for ranking projects in case of capital
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| Opportunity Cost of Capital | Expected rate of return given up by investing in a project
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| Risk and Present Value | Higher risk projects require a higher rate of return
Higher required rates of return cause lower PVs
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| Investment timing | Sometimes you have the ability to defer an investment and select a time that is more ideal at which to make the investment decision. E.g. you may defer the harvesting of trees, by doing so, you defer the receipt & increase the cash flow
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| Equivalent Annual Cost | The cash flow per period with the same present value as the cost of buying and operating a machine.
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| Capital Rationing | Limit set on the amount of funds available for investment.
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| Soft Rationing | Limits on available funds imposed by management (not by investors).
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| Hard Rationing |
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