Chapter 6: Making Decisions Using the NPV Rule

Making Decisions Using the NPV Rule from Principles of Corporate Finance provides a comprehensive guide on the practical application of the Net Present Value (NPV) rule for making capital investment decisions, moving beyond theory to the mechanics of forecasting project cash flows. A fundamental distinction is established between accounting profits and cash flows, emphasizing that financial managers must discount actual cash inflows and outflows rather than accounting income, which includes non-cash allocations. The text details the specific adjustments required to convert accounting data into free cash flow, such as adding back depreciation and subtracting capital expenditures, while also accounting for the timing differences caused by investments in Net Working Capital like inventory and accounts receivable. The chapter defines the rules for identifying incremental cash flows, instructing students to strictly ignore sunk costs—past irreversible expenses—while ensuring the inclusion of opportunity costs and any side effects a new project might have on the firm's existing business lines. Significant attention is given to corporate income taxes, explaining how depreciation expenses create valuable tax shields that reduce tax payments, and comparing the impacts of straight-line versus accelerated depreciation methods on project value. The discussion also covers the consistent treatment of inflation, mandating that nominal cash flows be discounted by nominal rates and real cash flows by real rates to avoid valuation errors. Finally, the chapter addresses the challenges of mutually exclusive projects, introducing the Equivalent Annual Cost (EAC) method to solve problems regarding investment timing, the choice between long-lived and short-lived equipment, and decisions on when to replace aging machinery.