6thCh11P - CHAPTER11 TheBasicsofCapitalBudgeting Should we...

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1 CHAPTER 11 The Basics of Capital Budgeting Should we build this plant?
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2 Steps 2.  Assess riskiness of CFs. 3.  Determine r = WACC (adj.). determine appropriate discount rate, based on riskiness of  4.  Find NPV and/or IRR. 5.  Accept if NPV > 0 and/or IRR > WACC.
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3 What is the payback period? The number of years required to recover a project’s cost, or how long does it take to get our money back? Calculated by adding project’s cash inflows to its cost until the  cumulative  cash flow  for the project turns positive. This is a method used by many small business owners.  Their rationale, ”if  I cannot get my investment back within ___ years, I cannot do the project,  even if there is a positive NPV, due to cash flows in the future.”
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4 Strengths and Weaknesses of  Payback Strengths Provides an indication of a project’s risk and liquidity. Easy  to calculate and understand. Rationale: Payback represents a type of “breakeven” analysis :   The payback period tells us when the project will break even in  a cash flow sense.   Weaknesses Ignores the time value of money . Ignores  CFs occurring  after the payback period.
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5 What are the two main disadvantages of  discounted payback?  Is the payback method of  any real usefulness in capital budgeting  decisions?   Regular payback has three critical deficiencies:  (1) It  ignores the time value of money.  (2) It ignores the cash  flows that occur after the payback period.  (3) Unlike the  NPV, which tells us by how much the project should  increase shareholder wealth, and the IRR, which tells us  how much a project yields over the cost of capital, the  payback merely tells us when we get our investment back.    Discounted payback does consider the time value of  money, but it still fails to consider cash flows after the  payback period and it gives us no specific decision rule for 
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6thCh11P - CHAPTER11 TheBasicsofCapitalBudgeting Should we...

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