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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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