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Chapter 6. Investment Decision Rules

Summary

  1. If your objective is to maximize wealth, the NPV rule always gives the correct answer.
  2. The difference between the cost of capital and the IRR is the maximum amount of estimation error that can exist in the cost of capital estimate without altering the original decision.
  3. Payback investment rule: Calculate the amount of time it takes to pay back the initialinvestment (the payback period). If the payback period is less than a prespecified length of time, accept the project. Otherwise, turn it down.
  4. IRR investment rule: Take any investment opportunity whose IRR exceeds the opportu-nity cost of capital. Turn down any opportunity whose IRR is less than the opportunitycost of capital.
  5. The IRR rule may give the wrong answer if the cash flows have an upfront payment (negative investment). When there are multiple IRRs or the IRR does not exist, the IRR rule cannot be used.
  6. The EVA in year n is the cash flow in that year minus the cost of tying up and using upthe capital required to run the project—it is the value added in that year over the life ofthe project:
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  7. EVA investment rule: Accept any investment opportunity in which the present value,using the project’s cost of capital r, of all future EVAs is positive.
  8. When choosing among mutually exclusive investment opportunities, pick the opportu-nity with the highest NPV. Do not use IRR to choose among mutually exclusive invest-ment opportunities.
  9. Incremental IRR rule: Assume you are comparing two mutually exclusive opportunities, A and B, and the IRRs of both opportunities exceed the cost of capital. If you subtract the cash flows of opportunity B from the cash flows of opportunity A, then you shouldtake opportunity A if the incremental IRR exceeds the cost of capital. Otherwise, take opportunity B.
  10. When choosing among projects competing for the same resource, ranking the projects by their profitability indices and picking the set of projects with the highest profitability indices that can still be undertaken given the limited resource often produces the best result.

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