Banking Chapter 7 Investment Decision Rules Outline The Following Outline Correlated The

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Chapter 7

Investment Decision Rules

I. Chapter Outline

The following chapter outline is correlated to the PowerPoint Lecture Slides. The PowerPoint slides

are referenced in bold. Alternative Examples to selected textbook examples are also available in the

PowerPoint Lecture Slides and are also referenced in bold.

7.1 NPV and Stand-Alone Projects (Slide 5)

• Applying the NPV Rule (Slide 6)

7.2 The Internal Rate of Return Rule (Slides 9–10)

• Applying the IRR Rule (Slide 11)

• Pitfall #1: Delayed Investments (Slides 12–15)

• Figure 7.2 NPV of Star’s $1 Million Book Deal (Slide 16)

• Pitfall #2: Multiple IRRs (Slides 17-19, 21)

• Figure 7.3 NPV of Star’s Book Deal With Royalties (Slide 20)

• Common Mistake: IRR Versus the IRR rule

• Pitfall #3: Nonexistent IRR (Slide 22)

7.3 The Payback Rule (Slide 31)

• Applying the Payback Rule

• Example 7.2 The Payback Rule (Slides 32–33)

7.4 Choosing Between Projects (Slide 37)

• NPV Rule and Mutually Exclusive Investments

• Example 7.3 NPV and Mutually Exclusive Projects (Slides 38-39)

• PowerPoint Alternative Example 7.3 (Slides 40–41)

• IRR Rule and Mutually Exclusive Investments

– Differences in Scale (Slides 42–43)

Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition 27

– Differences in Timing (Slide 44)

– Differences in Risk (Slide 45)

• The Incremental IRR (Slide 46)

7.5 Project Selection with Resource Constraints (Slide 57)

• Evaluating Projects with Different Resource Requirements (Slide 57)

• Profitability Index (Slide 58)

• Table 7.1 Possible Projects for a $100 Million Budget (Slide 57)

II. Learning Objectives

7.1 Define net present value, payback period, internal rate of return, profitability index, and

incremental IRR.

7.3 Given cash flows, compute the NPV, payback period, internal rate of return, and profitability

index for a given project, and compute the incremental IRR for a pair of projects.

7.5 Discuss the reasons IRR can give a flawed decision.

III. Chapter Overview

This chapter introduces techniques that firms use to evaluate investments and decide which projects

to pursue, including NPV, payback period, internal rate of return, profitability index, incremental

IRR, and EVA, with an emphasis on NPV. The chapter then covers choosing between projects when

they are mutually exclusive, and finally choosing between projects when there is a resource

constraint.

7.1 NPV and Stand-Alone Projects

The text emphasizes NPV as the only reliable way to make capital budgeting decisions. The internal

rate of return can provide a measure of the sensitivity of the NPV to changes in the opportunity cost

of capital. Because the IRR is the point at which NPV equals zero, it can be used to measure the

Berk/DeMarzo • Corporate Finance, Fourth Edition, Global Edition 29

IV. Spreadsheet Solutions in Excel

The following Problems for Chapter 7 have spreadsheet versions of the problems available: 5, 6, 8,

12, 15, 18, and 20.