# AFM273 Chapter Notes - Chapter 6: Payback Period, Net Present Value

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Published on 17 Feb 2015

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Chapter 6:

•The difference b/w the cost of capital and IRR is max. amount of estimation error in the

cost of capital estimate that can exist without altering the original decision

NPV Rule

•Accept project when NPV is positive

Internal Rate of Return (IRR) Investment Rule

•The rate of IRR is when NPV = 0

•Take investment where IRR > cost of capital. Turn down investment where IRR < cost of

capital

•IRR rule works if all of project’s negative cash flows precede its positive cash flows

•Situations where IRR rule and NPV rule may be in conflict:

oUnconventional cash flows

oMultiple IRRs

•No IRR exists because the NPV is positive for all values of the discount rate. Thus, IRR

rule cannot be used

•IRR rule has shortcomings for making investment decisions. IRR measures the average

return of the investment and the sensitivity of the NPV to any estimation error in the cost

of capital

Payback Rule

•Payback period is the amount of time it takes to recover or pay back initial investment. If

payback period is less than pre-specified length of time, accept the project

Mutually Exclusive Projects

•When you must choose only one project among several possible projects, choice is

mutually exclusive

•NPV rule – select project with highest NPV

•IRR rule – select project with highest IRR may lead to mistakes

oWhen projects differ in their scale of investment, timing of their cash flows, or

riskiness, then their IRRs cannot be meaningfully compared

Differences in Scale

•If project’s size is doubled, its NPV will double. This is not the case with IRR because

IRR measure average return of investment. Thus, IRR rule cannot be used to compare

projects of different scales

Differences in Timing