March28 - Capital Budgeting Approach: Capital budgeting is...

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1 Capital Budgeting: Part 2 Adam Presslee OfFce: HH384 Email: capressl@uwaterloo.ca Capital Budgeting Approach: Capital budgeting is a systematic approach to evaluating long-term investments and/or financing decisions 4 common approaches include: Payback period Accounting rate of return Net present value Internal rate of return Payback Period: The number of periods needed to recover a project’s initial investment: The point when a projects aggregate cash inflow equals the initial cost of the purchase. An ‘ undiscounted break-even’ calculation Disadvantages: Ignores the time value of money Ignores cashflows after payback Ignores qualitative factors Accounting Rate of Return (ARR): A projects average accounting income divided by the average level of investment: Average income = Cashflows – Depreciation Average investment = (Historical cost – Salvage value)/2 Advantages: Improvement over payback because it considers cashflows in all periods Disadvantages: Does not consider the timing of cashflows Inferior to net present value
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2 Net Present Value (NPV): The sum of present value of all cash inflows and outflows. Assumptions required include period length, capital cost, and estimated incremental cash flows. Advantages: Incorporates the time-value-of-money Allows for risky periods to be easily identified Generally superior to the other three methods Disadvantage: Often cumbersome to calculate Ignores qualitative factors (so do the other methods!) Internal Rate of Return (IRR):
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March28 - Capital Budgeting Approach: Capital budgeting is...

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