Net Present Value (NPV = PV – required investment) Present value of cash flows minus initial investments Opportunity Cost of Capital Expected rate of return given up by investing in a project Payback Period Time until cash flows recover the initial investment in the project. The payback rule specifies that a project be accepted if its payback period is less than the specified cutoff period Internal Rate of Return (IRR) Discount rate at which project NPV = 0 Rate of Return Rule Invest in any project offering a rate of return that is higher than the opportunity cost of capital IRR [It measures the profitability of the project, It is an internal rate of return, It depends only on the project’s own cash flows] Opportunity cost of capital [It is the standard for deciding whether to accept the project, It is equal to the return offered by equivalent-risk investments in the capital market] Pitfall 1 - Lending or Borrowing? [With some cash flows the NPV of the project increases as the discount rate increases, this is contrary to the normal relationship between NPV and discount rates] Pitfall 2 - Multiple Rates of Return Certain cash flows can generate NPV=0 at two different discount rates Pitfall 3 - Mutually Exclusive Projects IRR sometimes ignores the magnitude of the project Mutually Exclusive Projects : Two or more projects that cannot be pursued simultaneously. When you need to choose between mutually exclusive projects, the decision rule is
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