2 cap_budgeting_1.pptx - Capital Budgeting Selection Rules...

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Capital Budgeting Selection Rules
Chapter Outline The Payback Period Rule The Discounted Payback Period Rule The Internal Rate of Return Problems with the IRR Approach The Profitability Index Why Use Net Present Value? The Practice of Capital Budgeting Summary and Conclusions The Payback Period Rule The Discounted Payback Period Rule The Internal Rate of Return Problems with the IRR Approach The Profitability Index Why Use Net Present Value? The Practice of Capital Budgeting Summary and Conclusions
The Payback Period Rule How long does it take the project to “pay back” its initial investment? Payback Period = number of years to recover initial costs Minimum Acceptance Criteria: set by management How long does it take the project to “pay back” its initial investment? Payback Period = number of years to recover initial costs Minimum Acceptance Criteria: set by management
The Payback Period Rule (continued) Disadvantages: Ignores the time value of money Ignores cash flows after the payback period Biased against long-term projects Requires an arbitrary acceptance criteria Advantages: Easy to understand Quick to execute Disadvantages: Ignores the time value of money Ignores cash flows after the payback period Biased against long-term projects Requires an arbitrary acceptance criteria Advantages: Easy to understand Quick to execute
In-Class Problem You have been hired by Widget Co. last week. Your first job is to choose between the following two projects: Project 1 requires an investment of -\$200M in year 0 and will produce positive cash flows of \$40M, \$100M, \$60M, and \$10M in the next 4 years. Project 2 requires an investment of -\$200M in year 0 and will produce positive cash flows of \$40M, \$100M, \$60M, and \$400M in the next 4 years. You know that the payback method is not the best way to judge new projects, but your boss insists that that is the method they use (and the only one he can understand). Calculate the Payback period for the 2 projects. You have been hired by Widget Co. last week. Your first job is to choose between the following two projects: Project 1 requires an investment of -\$200M in year 0 and will produce positive cash flows of \$40M, \$100M, \$60M, and \$10M in the next 4 years. Project 2 requires an investment of -\$200M in year 0 and will produce positive cash flows of \$40M, \$100M, \$60M, and \$400M in the next 4 years. You know that the payback method is not the best way to judge new projects, but your boss insists that that is the method they use (and the only one he can understand). Calculate the Payback period for the 2 projects.
Solution Project 1: unpaid balance in year 1= -200+40=-160M \$ unpaid balance in year 2= -160+100=-60M \$ unpaid balance in year 3= -60+60= 0 \$ Payback period = 3 years Project 2: unpaid balance in year 1= -200+40=-160M \$ unpaid balance in year 2= -160+100=-60M \$ unpaid balance in year 3= -60+60= 0 \$ Payback period = 3 years Project 1: unpaid balance in year 1= -200+40=-160M \$ unpaid balance in year 2= -160+100=-60M \$ unpaid balance in year 3= -60+60= 0 \$ Payback period = 3 years Project 2: unpaid balance in year 1= -200+40=-160M \$ unpaid balance in year 2= -160+100=-60M \$ unpaid balance in year 3= -60+60= 0 \$ Payback period = 3 years
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