Section outline

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  • 1. Introduction

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    Welcome to the module "NPV and other Investment Decision Criteria"! This module introduces the most important investment decision criteria, in particular the Net Present Value (NPV) and the Internal Rate of Return (IRR).
     

     

    The main learning goals of this module are:
      • Know what a Net Present Value (NPV) is and how to compute the NPV of any cash flow stream.
      • Learn how to use the NPV rule in investment decisions.
      • Understand how and why managers who follow the NPV rule tend to increase the financial value of their firm.
      • Know how to compute and interpret the Internal Rate of Return (IRR) of projects and appreciate the strengths and weaknesses of this metric.
      • Know what the Payback is and understand why investment decisions based on payback are often flawed.
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  • 2. Net Present Value (NPV)

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    This section introduces the Net Present Value (NPV) and shows how managers can use the NPV to make sound investment decisions. The NPV is one of the most important tools in capital budgeting. It is therefore crucial that finance professionals know how to compute and interpret NPVs.

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  • 3. Foundations of the NPV Rule

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    Next, we take a closer look behind the scenes of the NPV rule. Using a simple example, we show how managers who follow the NPV rule make shareholders better off and how following the NPV rule can help to reconcile diverging preferences of investors. This also allows us to revisit some of the assumptions we make when working with (net) present values.

    Activities: 4

  • 4. Internal Rate of Return (IRR)

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    This section introduces the "little brother" of the NPV, the Internal Rate of Return (IRR). The IRR indicates the return that investors can expect to earn when investing in a project. For general investment projects, the IRR rule states that we should invest if the IRR exceeds the cost of capital. We show that IRR and NPV very often lead to identical investment decisions and that the main advantage of IRR is that it is easy to communicate and understand. Yet there are some very important implementation issues that we need to keep in mind when working with IRRs instead of NPVs.

    Activities: 4

  • 5. Payback Rule

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    Many practitioners require that projects repay the invested capital within a predefined period. While it is popular, especially in smaller firms, this payback rule is severely flawed. Still, we present the payback rule and show in detail what implementation challenges we face. While it is interesting to know a project's payback, we should not base investment decisions on this information.

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  • 6. Implementation Questions and Examples

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    In real life, there are often various alternatives to implement a specific project. The standard NPV rule as presented in the preceding section works well if the available alternatives are very comparable, for example regarding the required investment and the duration of the project. That need not necessarily be the case. 

    In this section, we look at somewhat more complex investment decisions that involve project alternatives with very different characteristics. We learn how to adjust the standard NPV-rule to make projects comparable and to align the NPV criterion with alternative criterias such as the IRR rule.

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