Quick Reference Guide

Corporate Finance Professional Certificate MOOC

Course 1: Introduction to Corporate Finance
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.
𝐶) Profitability Index Formula
𝑁𝑃𝑉 = 𝐶& + ⋯ 𝑁𝑃𝑉
(1 + 𝑟 ))
NPV = Net Present Value
𝑃𝐼 =
𝐶&
𝐶& = Initial Investment PI = Profitability Index
Ct = Cash Flow at period t 𝐶& = 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.