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**Unformatted text preview: **CAPITAL BUDGETING PROFIT ANALYSIS Profit Measures 1. Payback 1. Net Present Value (NPV) 1. Internal Rate of Return (IRR) Payback: Measures how long it takes to recover the investment cost Assumes cash flows are received evenly throughout the year Investment A - Annuity cash flows Investment cost $40,000 Cash inflow $10,000 per year Investment life 6 years Payback = $40,000/$10,000 = 4 years Decision rule: If the payback period is lower than the maximum, set by the company, accept the investment Investment B - non-annuity cash flows Investment cost $20,000 Year Cash Inflow Cumulative Cash Flow 1 $10,000 2 6,000 3 3,000 4 2,000 5 1,000 6 1,000 Investment B - non-annuity cash flows Investment cost $20,000 Year Cash Inflow Cumulative Cash Flow 1 $10,000 $10,000 2 6,000 16,000 3 3,000 19,000 4 2,000 1,000/2,000 = 0.5 years 5 1,000 6 1,000 Payback period = 3.5 years Paybacks Problems: 1. It does not measure profitability 2. It does not consider cash flows beyond the payback period 3. It does not use time value adjustments Investment 0 1 2 3 4 5 A -$10,000 5,000 5,000 B -$10,000 5,000 5,000 C -$10,000 5,000 5,000 Payback method ranks all equally, at 2 years Paybacks Problems: 1. It does not measure profitability 2. It does not consider cash flows beyond the payback period 3. It does not use time value adjustments Investment 0 1 2 3 4 5 A -$10,000 5,000 5,000 B -$10,000 5,000 5,000 5,000 C -$10,000 5,000 5,000 5,000 5,000 5,000 Payback method ranks all equally, at 2 years Even though the payback periods are equal are these three investments equally good? NPV & IRR...

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