Summary And Conclusions

This chapter has covered the different criteria used to evaluate proposed investments. The six criteria, in the order we discussed them, are:

1. Net present value (NPV)

2. Payback period

3. Discounted payback period

4. Average accounting return (AAR)

5. Internal rate of return (IRR)

6. Profitability index (PI)

We illustrated how to calculate each of these and discussed the interpretation of the results. We also described the advantages and disadvantages of each of them. Ultimately, a good capital budgeting criterion must tell us two things. First, is a particular

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

9. Net Present Value and Other Investment Criteria

© The McGraw-Hill Companies, 2002

CHAPTER 9 Net Present Value and Other Investment Criteria project a good investment? Second, if we have more than one good project, but we can take only one of them, which one should we take? The main point of this chapter is that only the NPV criterion can always provide the correct answer to both questions.

For this reason, NPV is one of the two or three most important concepts in finance, and we will refer to it many times in the chapters ahead. When we do, keep two things in mind: (1) NPV is always just the difference between the market value of an asset or project and its cost, and (2) the financial manager acts in the shareholders' best interests by identifying and taking positive NPV projects.

Finally, we noted that NPVs can't normally be observed in the market; instead, they must be estimated. Because there is always the possibility of a poor estimate, financial managers use multiple criteria for examining projects. The other criteria provide additional information about whether or not a project truly has a positive NPV.

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