Chapters 2 and 3 introduced the concept of net present value (NPV) and its use for making investment or capital budgeting decisions. This chapter starts with a review of the NPV approach to investment decision making and then presents three other widely used measures. These are:

• the book rate of return,
• the payback period, and
• the internal rate of return (IRR).

The chapter describes these methods and their major drawbacks. The measures are inferior to the NPV and should not, with the qualified exception of the IRR, normally be relied upon to provide sound corporate investment decisions. The IRR can provide correct and sound decisions if used properly. The primary reason why a chapter is devoted to these measures is that these are commonly used in corporate practice and are often popular. Hence, you should understand the methods and the pitfalls in their use.

The chapter also describes how to take capital budgeting decisions when one is faced with the so-called capital rationing problem. This introduces a fourth method called the profitability index. More complex constraints can be dealt with using a technique called linear programming.