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Chapter 10 FIN - Chapter 10 Finding Profitable Projects...

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Chapter 10 Finding Profitable Projects Capital budgeting: the process of decision making with respect to investments made in fixed assets – that is, should a proposed project be accepted or rejected. Capital Budgeting Decision Criteria Payback period: the number of years it takes to recapture a project’s initial outlay. - Ignores TVM and does not discount these free cash flows back to the present - Project A returns more of our initial investment to us faster within the payback period, so we would want to take this project first - Choice of the max desired payback period is arbitrary, that is, there is no good reason why the firm should accept projects that have payback periods less than or equal to 3 years rather than 4 years. - Positives: deals with cash flows as opposed to account profits, easy to calculate, may make sense for a firm that needs funds and is having problems raising additional money. Discounted payback period: the number of years it takes to recapture a project’s initial outlay using discounted cash flows - Used because it deals with TVM. - Limited by aribtrariness of the process used to select the max desired payback period. Net Present Value Net present value: the present value of an investment’s annual free cash flows less the investments initial outlay. = (present value of all the future annual free cash flows) – (initial cash outlay) = PV benefits – PV costs - Deals with free cash flows, recognizes time value of money -
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