1. Understand that the net present value of an investment project is defined as the present value of the stream of expected net cash flows from the project minus the project’s net investment
a. A project is acceptable if its NPV is greater than or equal to zero
b. By maximizing the net present value of accepted projects, a firm will also maximize shareholder wealth
2.Understand that the profitability index (PI) is the ratio of the present value of expected net cash flows over the life of the project to the net investment
a. If the project has a PI equal to or greater than 1.0, it is acceptable
b. The PI can be used as a guide to resource allocation in capital rationing situations
3. Understand that the internal rate of return (IRR) is defined as the discount rate that equates the present value of the expected net cash flows from a project with the present value of the net investment
a. A normal project is acceptable if it has an IRR greater than or equal to the firm’s cost of capital. A normal project has an initial cash outlay or outlays followed by a stream of positive net cash flows
b. The NPV and IRR approaches give the same accept-reject signals for independent normal projects
c. The IRR approach can lead to multiple internal rates of return for nonnormal projects. When this occurs, none of these rates can be compared to the firm’s cost of capital to determine the project’s acceptability
4. Understand that the payback period of an investment is the period of time required for the cumulative cash inflows (net cash flows) from a project to equal the initial cash outlay
a. Weaknesses of the payback method include that it ignores the timing of cash flows and cash flows beyond the payback period
b. The payback technique can be used as a project liquidity measure and as a crude risk-screening technique
5. Understand that a firm may face a limit on the capital available (capital rationing) in some situations
a. Soft rationing occurs when the constraint is self-imposed
