Fin320-CH9 - FIN 320 Chapter #9: Capital Budgeting Christo...

Info iconThis preview shows pages 1–13. Sign up to view the full content.

View Full Document Right Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: FIN 320 Chapter #9: Capital Budgeting Christo Pirinsky NPV & Other Investment Criteria Chapter 9 Outline The Payback Rule Net Present Value The Internal Rate of Return The Practice of Capital Budgeting Capital Budgeting Capital Budgeting is the process of planning for purchases of long-term assets. Example : Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide? Will the machine be profitable? Will our firm earn a high rate of return on the investment? Decision making Criteria How do we decide if a capital investment project should be accepted or rejected? Decision-making Criteria in Capital Budgeting The Ideal Evaluation Method should: 1. consider the time value of money , 2. consider the riskiness of the project, (by incorporating the required rate of return on the project), 3. include all cash flows that occur during the life of the project, 4. provide information on whether the project is creating value for the firm. Decision-making Criteria in Capital Budgeting Three Basic Methods of Evaluating Projects 1. Payback Method 1. Net Present Value (NPV) 1. Internal Rate of Return (IRR) Payback Period How long will it take for the project to generate enough cash to pay for itself? 1 1 2 2 3 3 4 4 5 5 8 8 6 6 7 7 (500) 150 150 150 150 150 150 150 150 (500) 150 150 150 150 150 150 150 150 Payback period = Payback period = 3.33 years. 3.33 years. Is a 3.33 year payback period good? Is it acceptable? Firms that use this method will compare the payback calculation to some standard set by the firm. If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision? ACCEPT THE PROJECT. Payback Period BUAD 215 NPV & Other Investment Criteria Decision Criteria Test – Payback Does the payback rule account for the time value of money? Does the payback rule account for the risk of the cash flows? Does the payback rule provide an indication about the increase in value? Should we consider the payback rule for our primary decision criteria? Firm cutoffs are subjective. Does not consider time value of money. Does not consider any required rate of return. Does not consider all of the project’s cash flows. Does not clearly indicate if the project creates value for the firm. Drawbacks of the Payback Period Does not consider all of the project’s cash flows. This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion! 1 1 2 2 3 3 4 4 5 5 8 8 6 6 7 7 (500) 150 150 150 150 150 (300) 0 0 (500) 150 150 150 150 150 (300) 0 0 Drawbacks of the Payback Period FIN320 Advantages & Disadvantages of Payback Advantages Easy to understand Adjusts for uncertainty of later cash flows Biased towards liquidity Disadvantages Ignores the time value of money Requires an arbitrary cutoff...
View Full Document

This note was uploaded on 04/15/2009 for the course FINANCE FIN 320 taught by Professor Cpirinski during the Spring '09 term at CSU Fullerton.

Page1 / 47

Fin320-CH9 - FIN 320 Chapter #9: Capital Budgeting Christo...

This preview shows document pages 1 - 13. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online