Chapter 8: Net Present Value and Other Investment Criteria

IRR

The IRR on an investment is the required return that results in a zero NPV when it is used as the discount rate.

payback period

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

net present value (NPV)

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

internal rate of return (IRR)

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

multiple rates of return

The possibility that more than one discount rate makes the NPV of an investment zero.

profitability index (PI)

The present value of an investment's future cash flows divided by its initial cost. Also, benefit-cost ratio.

average accounting return (AAR)

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

The Internal Rate of Return Rule

Based on the IRR rule, an investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.

The Average Accounting Return

Based on the average accounting return rule, a project is acceptable if its average accounting return exceeds a target average accounting return.

The Payback Rule

Based on the payback rule, an investment is acceptable if its calculated payback period is less than some prespecified number of years.

net present value profile

A graphical representation of the relationship between an investment's NPV and various discount rates.

mutually exclusive investment decisions

A situation where taking one investment prevents the taking of another.

Net Present Value Rule

An investment should be accepted if the net present value is positive and rejected if it is negative.

discounted cash flow (DCF) valuation

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