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Unformatted text preview: FNCE 3010 (Durham) HW 16 capital budgeting 1 1. For each of the capital budgeting decision criteria discussed in this chapter, describe the decision rule and briefly discuss the advantages and disadvantages of the rule. Solution: Payback period is simply the accounting break-even point of a series of cash flows. Given some predetermined cutoff for the payback period, the deci- sion rule is to accept projects that payback before this cutoff, and reject projects that take longer to payback. The worst problem associated with payback period is that it ignores the time value of money. In addition, the selection of a hurdle point for payback period is an arbitrary exercise that lacks any steadfast rule or method. And finally, the payback period ignores any cash flows that occur after the cutoff point (e.g., clean-up costs). Despite its shortcomings, payback is often used because (1) the analysis is straightforward and simple and (2) accounting numbers and estimates are readily available. Since payback is biased towards liquidity, it may be a useful method for short-term projects where cash management is most important. It may also be useful in situations where long-term cash flows are highly uncertain. Discounted payback is calculated in a similar manner to regular payback, with the exception that each cash flow in the series is first converted to its present value. Thus discounted payback provides a measure of fi- nancial/economic break-even (because of the discounting), just as regular payback provides a measure of accounting break-even. Given some pre- determined cutoff for the discounted payback period, the decision rule is to accept projects whose discounted cash flows payback before this cutoff period, and to reject all other projects....
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- Fall '07
- Corporate Finance