CHAPTER FIVE WHY NET PRESENT VALUE LEADS TO BETTER INVESTMENT DECISIONS THAN OTHER CRITERIA Four chapters we introduced, at times surreptitiously, most of the basic principles of the investment decision. In this chapter we begin by consolidating that knowledge. We then take a look at three other measures that companies | Brealey-Meyers I. Value 5. Why Net Prsnt Value The McGraw-Hill Principles of Corporate Leads to Better Companies 2003 Finance Seventh Edition Investments Decisions CHAPTER FIVE Brealey-Meyers Principles of Corporate Finance Seventh Edition I. Value 5. Why Net Prsnt Value Leads to Better Investments Decisions than Other Criteria The McGraw-Hill Companies 2003 IN THE FIRST four chapters we introduced at times surreptitiously most of the basic principles of the investment decision. In this chapter we begin by consolidating that knowledge. We then take a look at three other measures that companies sometimes use when making investment decisions. These are the project s payback period its book rate of return and its internal rate of return. The first two of these measures have little to do with whether the project will increase shareholders wealth. The project s internal rate of return if used correctly should always identify projects that increase shareholder wealth. However we shall see that the internal rate of return sets several traps for the unwary. We conclude the chapter by showing how to cope with situations when the firm has only limited capital. This raises two problems. One is computational. In simple cases we just choose those projects that give the highest NPV per dollar of investment. But capital constraints and project interactions often create problems of such complexity that linear programming is needed to sort through the possible alternatives. The other problem is to decide whether capital rationing really exists and whether it invalidates net present value as a criterion for capital budgeting. Guess what NPV properly interpreted wins out in the end. A REVIEW OF THE BASICS Vegetron s chief financial officer CFO is wondering how to analyze a proposed 1 million investment in a new venture called project X. He asks what you think. Your response should be as follows First forecast the cash flows generated by project X over its economic life. Second .
