3. Investment Decision Criteria

d. calculate and interpret net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI) of a single capital project;

What is Net Present Value (NPV) and what is the formula? - NPV discounts all cash flows (including both inflows and outflows) at the project’s cost of capital and then sums those cash flows. The project is accepted if the NPV is positive. - \(NPV = \sum(\frac{CF_t}{(1 + k)^t})\)

What are decision rules related to NPV? - The higher the NPV, the better. - Reject if NPV is less than or equal to 0.

What is Internal Rate of Return (IRR) and what is the formula? - IRR is the discount rate that forces a project’s NPV to equal zero. - \(NPV = \sum(\frac{CF_t}{(1 + IRR)^t})\) - This is just the NPV formula solved for a particular discount rate that forces NPV to equal zero

What is Payback Period? Payback period is the expected number of years required to recover the original investment. Payback occurs when the cumulative net cash flow equals 0.

What is Discounted Payback Period? Discounted payback period is similar to the regular payback method except that it discounts cash flows at the project’s cost of capital. It considers the time value of money, but it ignores cash flows beyond the payback period.

What is the Profitability Index (PI) and what is the formula? - is an index used to evaluate proposals for which net present values have been determined. The profitability index is determined by dividing the present value of each proposal by its initial investment. - \(PI = \frac{PV\ of\ future\ cash\ flows}{initial\ investment} = 1 + \frac{NPV}{initial\ investment}\)