Key Terms
Capital Budgeting
The process a company uses to evaluate potential major investments or projects.
Payback Period
How long it takes for a project's cash inflows to fully recover the initial investment. No time value of money adjustmen
Net Present Value (NPV)
Present value of all cash inflows minus present value of all cash outflows. Positive NPV means the project adds value; a
Internal Rate of Return (IRR)
The discount rate that makes NPV equal to zero. If IRR exceeds the cost of capital, accept the project.
Profitability Index (PI)
Present value of cash inflows divided by present value of cash outflows. PI greater than 1 means accept; less than 1 mea
Discounted Payback Period
Same concept as payback period, but cash flows are discounted first using the cost of capital. Still has major weaknesse
Modified Internal Rate of Return (MIRR)
A variation of IRR that fixes the reinvestment rate assumption by compounding all cash inflows at the cost of capital in
Mutually Exclusive Projects
Projects that compete with each other; choosing one means you cannot choose the other.
Replacement Chain Approach
Repeat the shorter project as many times as needed to match the length of the longer project. Then compare the total NPV
Equal Annuity Approach
Compares projects with different lives by converting each project's NPV into an equivalent annual annuity; assumes both
Payback period
4 years. Balance hits zero in year 4.
Formula
Present Value of Cash Inflows divided by Present Value of Cash Outflows.
Decision rule
PI greater than 1, accept. PI less than 1, reject.
Still has two major flaws
No objective acceptance criterion, and cash flows after breakeven are still ignored.
What MIRR fixes
The reinvestment rate assumption. All cash flows are compounded at the cost of capital, not at the IRR.