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Chapter 7. Cap budgeting - Investment decision rules

Chapter 7. Cap budgeting - Investment decision rules - Cap...

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Cap Budgeting - Investment Decision Rules Chapter 7 Finance 357
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NPV Rule NPV discounts cash flows to period 0 and then compares them Accept a project if the NPV is > 0 Reject a project if the NPV is < 0 Accepting positive NPV projects benefits stockholders by creating wealth. The value of the firm rises by the NPV of the project
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Are Alternatives to NPV good? Benefits of NPV 1. NPV uses cash flow 2. NPV uses all cash flows of a project 3. NPV discounts cash flows properly (TVM) Alternative methods Payback Period Discounted Payback Period Average Accounting Return Internal Rate of Return Profitability Index
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Payback Period Method The Payback Period Method of capital budgeting is interested in how long it takes for a project to bring in enough cash flows to break even or pay itself off. A rule is set to determine the maximum time allowed for projects to pay themselves back. Year Cash Flow 0 - $10,000 1 $ 5,000 2 $ 5,000 3 $ 5,000
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Payback Period Method In this project, it takes 2 years to repay the original $10,000 spent on the project. Year Cash Flow Paid Back 0 - $10,000 1 $ 5,000 5,000 2 $ 5,000 10,000 3 $ 5,000
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Payback Period Rule The payback period rule states that all projects must be paid back before a particular cutoff date. This date is arbitrary and up to management to select.
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Payback Period Example Alpha Inc. is considering a project with the following cash flows. Alpha Management has decided that all projects must pay themselves back within 3 years. Using the Payback Period Method, should Alpha accept this project? Year Cash Flow 0 - $125,000 1 $ 5,000 2 $ 90,000 3 $ 20,000 4 $100,000 5 $100,000
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Payback Period Example Alpha Inc. is considering a project with the following cash flows. Alpha Management has decided that all projects must pay themselves back within 3 years. Using the Payback Period Method, should Alpha accept this project? After 3 years, only $115,000 is repaid. The project should not be accepted. Year Cash Flow Paid Back 0 - $125,000 1 $ 5,000 5,000 2 $ 90,000 95,000 3 $ 20,000 115,0000 4 $100,000 5 $100,000
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Problems with Payback Method Problems with Payback Method 1. Timing of cash flows within payback period are not considered 2. Payments after the payback period are ignored 3. Arbitrary standard for payback period What are some instances where the payback method makes sense?
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Discounted Payback Period Method To correct one flaw of the Payback Period Method, the Discounted Payback Period Method discounts cash flows before calculating the payback period.
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