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  3. The University Of Manchester (UOM)
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  5. Bsc Management
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  7. Foundations of Finance

Lecture notes

Investment Decision Rules

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The notes cover important aspect of the investment techniques. Both Net Present Value and Internal Rate of Return are explained in detail including the fallacies of IRR rule. Formula for payback rule and profitability index is also included.

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  • November 14, 2015
  • 3
  • 2015/2016
  • Lecture notes
  • Unknown
  • Lecture 3

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Foundations of finance
Lectures 3: Investment decision rules


Techniques to compare between different investment decisions:

The Net Present Value Rule:
AS the name states NPV calculates the present value of all the cash flows occurring in the
future by discounting them back at a given rate. The project is accepted if the NPV is
positive and rejected if the NPV is negative.

Consider a project in which there is an initial cash outflow in year 0 and then inflow of C1,
C2 and C3 respectively in year 1,2 and 3. If r id the discounting rate then the NPV of the
project would be:

𝐶1 𝐶2 𝐶3
𝑁𝑃𝑉 = −𝐶0 + + +
(1 + 𝑟) (1 + 𝑟)2 (1 + 𝑟)3

 Therefore the NPV and the discounting rate have a negative relationship for
conventional projects.
 If the expected cash flow constitute a perpetuity :
𝐶
𝑁𝑃𝑉 = −𝐶0 +
𝑟
Where C0 represents the initial cash outflow and C represents the cash inflows that occur
forever.

NPV and discount rate:

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