Summary-C3

1.What is the net present value of an investment, and how do you calculate it?

The net present value of a project measures the difference between its value and cost. NPV

is therefore the amount that the project will add to shareholder wealth. A company

maximizes shareholder wealth by accepting all projects that have a positive NPV.

2.How is the internal rate of return of a project calculated and what must one look

out for when using the internal rate of return rule?

Instead of asking whether a project has a positive NPV, many businesses prefer to ask

whether it offers a higher return than shareholders could expect to get by investing in the

capital market. Return is usually defined as the discount rate that would result in a zero

NPV. This is known as the internal rate of return, or IRR. The project is attractive if the

IRR exceeds the opportunity cost of capital.

There are some pitfalls in using the internal rate of return rule. Be careful about using

the IRR when (1) the early cash flows are positive, (2) there is more than one change in the

sign of the cash flows, or (3) you need to choose between two mutually exclusive projects.

3.Why don’t the payback rule and book rate of return rule always make shareholders

better off?

The net present value rule and the rate of return rule both properly reflect the time value of

money. But companies sometimes use rules of thumb to judge projects. One is the payback

rule, which states that a project is acceptable if you get your money back within a specified

period. The payback rule takes no account of any cash flows that arrive after the payback

period and fails to discount cash flows within the payback period.

Book (or accounting) rate of return is the income of a project divided by the book

value. Unlike the internal rate of return, book rate of return does not depend just on the

project’s cash flows. It also depends on which cash flows are classified as capital

investments and which as operating expenses. Managers often keep an eye on how projects

would affect book return.

4.How can the net present value rule be used to analyze three common problems that

involve competing projects: when to postpone an investment expenditure; how to

choose between projects with equal lives; and when to replace equipment?

Sometimes a project may have a positive NPV if undertaken today but an even higher NPV

if the investment is delayed. Choose between these alternatives by comparing their NPVs

today.

When you have to choose between projects with different lives, you should put them on

an equal footing by comparing the equivalent annual cost or benefit of the two projects.

When you are considering whether to replace an aging machine with a new one, you should

compare the cost of operating the old one with the equivalent annual cost of the new one.

5.How is the profitability index calculated, and how can it be used to choose between

projects when funds are limited?

If there is a shortage of capital, companies need to choose projects that offer the highest net

present value per dollar of investment. This measure is known as the profitability index.