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5.CapBud.IRR - Capital Budgeting:alternative criteria Net...

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1 Capital Budgeting:alternative criteria Net Present Value (NPV) NPV = CF 0 + CF 1 (1 + r 1 ) + ... + CF t (1 + r t ) t Definition: Advantages: 1. Explicitly incorporates the time value of money. 2. Uses forecasted project cash flows and a risk adjusted discount rate. Does not rely on accounting methods, managerial risk preferences or the profitability of the company ʼ s existing business. 3. NPVs are additive .
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2 NPV RULE: Invest if NPV> 0 for independent projects. For mutually exclusive projects, accept the project with the highest positive NPV. Payback and Discounted Payback Definition: The time it takes to recover the initial investment. Advantages: Simplicity Disadvantages: Ignores discounting. Ignores cfs after payback period. Arbitrary
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3 Example A proposal requires a start-up investment of $250 and will generate $35 in perpetuity. Your Company has a payback cutoff of 5 years. Would this project be accepted? Internal Rate of Return (IRR) An IRR is, by definition, that discount rate that equates a project’s NPV to zero.
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