Finance Chapter 6 Study Notes- Jerry Wu

Comparing Investment Decision Rules
a) Discounted Payback period Method-discount cash flows and then find out how long it takes for the discounted cash flows to equal initial investment.
b) Average Accounting Return
c) IRR- Internal Rate of Return- IRR is the rate that causes NPV of the project to be Zero,
d) Profitability Index- PI= PV of cash flows subsequent to initial Investment/Initial Investment
e) Net Present Value Method- As shown in Chapter 5 - Advocated for people in the finance field

-IRR approach always reaches the same decision as NPV in the normal case where initial outflows of an independent investment project are followed only by a series of inflows.

Independent Project- A project whose acceptance or rejection is independent of the acceptance or rejection of other projects.
Mutually Exclusive Investments- Accept A or B, reject both of them, but cannot choose A and B at the same time.

When a project is an investing type project, (initial cash flow is negative), when IRR> discount Rate - Accept the project. When IRR < discount Rate- Reject the project

eg (-100, 50, 80)

When a project is a Financing type project- (initial cash flow is positive), when IRR >discount Rate- Reject the project. When IRR < discount Rate- Accept the project.

eg (100, -60, -90)

-Due to differences in size or timing, the project with the highest IRR need not have the highest NPV. Hence IRR rule should not be applied in this instance. NPV should still be applied.
Incremental IRR- Subtracting cash flow of A from the cash flows of B and then calculate IRR. (Subtracting the cash flows of the smaller project from the cash flows of the larger project, this way the incremental initial cash flow is negative). If the Incremental IRR is > discount Rate, then accept the larger project.

page revision: 2, last edited: 20 May 2010 17:10