• Global Frameworks: US CMA Part 2 (Corporate Financial Decisions), IFRS IAS 36 / US GAAP ASC 360.

1. Net Present Value (NPV) Decision Rules
Net Present Value (NPV) measures the total net dollar change in shareholder wealth resulting from a capital project. It discounts all projected cash inflows and outflows to the present using the project’s required rate of return (hurdle rate):

NPV = Σ [ CFₜ / (1 + r)ᵗ ] for t = 0 to N
  • Decision Rule: Accept projects where NPV > 0. A positive NPV means the project covers its operating costs, satisfies the required return for debt and equity holders, and creates additional value for equity shareholders.

2. Internal Rate of Return (IRR) and the Reinvestment Rate Paradox
The Internal Rate of Return (IRR) is the discount rate that forces the NPV of a project to equal zero:

Σ [ CFₜ / (1 + IRR)ᵗ ] = 0 for t = 0 to N
  • Decision Rule: Accept projects where IRR > Cost of Capital.
  • The Reinvestment Rate Paradox: NPV assumes that intermediate cash inflows are reinvested at the project’s cost of capital (a conservative and realistic assumption). IRR assumes intermediate cash flows are reinvested at the project’s IRR. If a project has an exceptionally high IRR (e.g., 45%), assuming the firm can routinely reinvest cash flows at 45% is unrealistic, making IRR less reliable for mutually exclusive project rankings.

3. Modified Internal Rate of Return (MIRR)
To resolve the reinvestment rate flaw of the standard IRR, financial managers use the Modified Internal Rate of Return (MIRR). MIRR assumes that cash inflows are reinvested at the firm’s cost of capital, while cash outflows are discounted at the financing rate:

MIRR = ⁿ√ [ Terminal Value of Inflows / Present Value of Outflows ] − 1

4. Payback Period and Discounted Payback Period
  • Payback Period: Measures the time required for a project to recover its initial cash outflow from nominal un-discounted cash inflows.
    • Flaws: Ignores the time value of money and all cash flows occurring after the payback cutoff date.

  • Discounted Payback Period: Addresses the time value flaw by discounting cash inflows before calculating the recovery timeline. It still fails to account for cash flows generated beyond the recovery window.

5. Profitability Index (PI) under Capital Rationing
When a firm faces a capital budget cap and cannot fund all positive NPV projects, it uses the Profitability Index (PI) to maximize value per dollar spent:

PI = Present Value of Future Cash Flows / Initial Investment = 1 + (NPV / Initial Investment)
  • Decision Rule: Rank projects by highest PI to select the optimal combination under strict capital rationing constraints.

 
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