Module 2, Capital Budgeting Notes Capital Budgeting: NPV & IRR Profitability and Payback Net Present Value (NPV) Profitability Index The sum of all discounted cash flows, including all Is the profitability of a project divided by the the costs and benefits. initial investment. It is a measure of the Net Present Value Formula value created per dollar invested. %) Profitability Index Formula !"# = %& + ⋯ !"# (1 + ,)) ". = NPV = Net Present Value %& %& = Initial Investment PI = Profitability Index Ct = Cash Flow at period t %& = Initial Investment r = discount rate NPV = Net Present Value t = number of periods Payback Rule NPV Rule Accept projects in which you will recover the When considering one project, you should take initial investment in a short amount of time. the project every time the NPV is positive. Payback Period If you are considering multiple projects, but can The number of years it takes to recoup your only take a subset of them (e.g. due to capital investment constraints), take the feasible combination with Cutoff Number or Threshold the highest NPV. To compute the combined NPV The maximum acceptable length of time by of multiple projects, simply add the NPV of the which payback must be achieved individual projects.
The IRR (Internal Rate of Return) of a Project
The rate of return at which the NPV of a project is 0. The IRR is a measure of profitability. IRR Rule When considering one project, you should take a project every time the IRR is higher than the cost of capital. Note however, that this rule sometimes fails as shown in the video with the L and B projects. NPV and IRR Disagreement When the NPV Rule and IRR Rule give you different recommendations, you should follow the NPV Rule.