Chapter 5: Net Present Value & Investment Decision Rules

Chapter 5 explains why net present value (NPV) is the most reliable criterion for evaluating investment decisions and compares it with alternative methods commonly used in practice. The chapter begins by reviewing the NPV rule, emphasizing that firms maximize shareholder wealth by accepting projects with positive NPVs, calculated by discounting forecast cash flows at the appropriate opportunity cost of capital. It then critiques other decision rules—payback period and accounting rate of return—for ignoring key elements such as the time value of money, risk, and complete cash-flow timing. The internal rate of return (IRR) is introduced as a more sophisticated alternative that often agrees with NPV for conventional projects, but the chapter highlights several pitfalls, including multiple IRRs, misleading rankings when projects are mutually exclusive, and complications when discount rates differ across time. Finally, the discussion turns to capital rationing and the profitability index as a tool for allocating scarce resources, while reaffirming that properly applied NPV remains the most consistent and value-maximizing investment criterion.