What is the net present value of an investment, andhow do you calculate it?The net present value of a project measures the differencebetween its value and cost. NPV is therefore theamount that the project will add to shareholder wealth.A company maximizes shareholder wealth by acceptingall projects that have a positive NPV.
How is the internal rate of return of a project calculated,and what must one look out for when using theinternal rate of return rule?Instead of asking whether a project has a positive NPV,many businesses prefer to ask whether it offers a higherreturn than shareholders could expect to get by investing inthe capital market. Return is usually defined as the discountrate that would result in a zero NPV. This is known as theinternal rate of return, or IRR. The project is attractive ifthe IRR exceeds the opportunity cost of capital.There are some pitfalls in using the internal rate ofreturn rule. Be careful about using the IRR when (1) theearly cash flows are positive, (2) there is more than onechange in the sign of the cash flows, or (3) you need tochoose between two mutually exclusive projects.
Why don’t the payback and discounted payback rulesand the book rate of return rule always make shareholdersbetter off?The net present value rule and the rate of return rule bothproperly reflect the time value of money. But companiessometimes use rules of thumb to judge projects. One isthe payback rule, which states that a project is acceptableif you get your money back within a specified period. Thepayback rule takes no account of any cash flows thatarrive after the payback period and fails to discount cashflows within the payback period.The discounted payback rule improves upon the paybackrule by examining discounted cash flows. It states that aproject is acceptable if the discounted cash flows recoveryour initial investment within a specified period.Book (or accounting) rate of return is the incomeof a project divided by the book value. Unlike the internalrate of return, book rate of return does not depend just onthe project’s cash flows. It also depends on which cashflows are classified as capital investments and which asoperating expenses. Managers often keep an eye on howprojects would affect book rate of return.
How can the net present value rule be used to analyzethree common problems that involve competing projects:when to postpone an investment expenditure;how to choose between projects with equal lives; andwhen to replace equipment?Sometimes a project may have a positive NPV if undertakentoday but an even higher NPV if the investment isdelayed. Choose between these alternatives by comparingtheir NPVs today.When you have to choose between projects withdifferent lives, you should put them on an equal footingby comparing the equivalent annual cost or benefit ofthe two projects. When you are considering whether toreplace an aging machine with a new one, you shouldcompare the cost of operating the old one with the equivalentannual cost of the new one.
How is the profitability index calculated, and how canit be used to choose between projects when funds arelimited?If there is a shortage of capital, companies need to chooseprojects that offer the highest net present value per dollar ofinvestment. This measure is known as the profitabilityindex.
