Corporate Finance Theory and Practice, Third Edition

Chapter 29

INVESTMENT 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.

Net present value (NPV) measures the value created by the investment and is the best criterion for selecting or rejecting an investment, whether it is industrial or financial. When it is simply a matter of deciding whether or not to make an investment, NPV and IRR produce the same outcome. However, if the choice is between two mutually exclusive investments, net present value is more reliable than the internal rate of return.

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 future financial managers, you should nevertheless be aware of them, even if they are more pertinent to accounting work than financial management.

Section 29.1 ...