Corporate Finance, 6th Edition

Chapter 28INVESTMENT CRITERIA

Back to flows and financial analysis

The “mathematics” we studied in Chapters 16 and 17, dealing with present value and internal rate of return, can also be applied to investment decisions and financial securities. These theories will not be covered again in detail, since the only real novelty is of a semantic nature. In the sections on financial securities, we calculated the yield to maturity. The same approach holds for analysing industrial investments, whereby we calculate a rate that takes the present value to zero. This is called the internal rate of return (IRR). Internal rate of return and yield to maturity are thus the same.

This chapter will discuss:

• the cash flows to be factored into investment decisions, which are called incremental cash flows; and
• other investment criteria, which are less relevant than NPV and IRR and have proven disappointing in the past. As financial managers, you should nevertheless be aware of them, even if they are more pertinent to accounting work than financial management: payback period, accounting rate of return, profitability indicator.

Section 28.1 THE PREDOMINANCE OF NPV AND THE IMPORTANCE OF IRR

Each investment has a net present value (NPV), which is equal to the amount of value created. Remember that the net present value of an investment is the value of the positive and negative cash flows arising from an investment, discounted at the rate of return required by the market. The rate of return is ...