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Chapter%209

# Chapter%209 - FIN3100 Chapter 9 Capital Budgeting Criteria...

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FIN3100: Chapter 9 Capital Budgeting Criteria

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Learning Objectives 1. Understand four decision tools: Payback NPV IRR Profitabilty index 1. Compare and contrast the strengths and weaknesses of each decision model.
Payback Criteria When do we first recover the initial cost? The method assumes that all cash outflows occur at the beginning of the project, followed by a stream of inflows. Also assumes that cash inflows occur uniformly over the year. Computation Estimate the cash flows Subtract the future cash flows from the initial cost until the initial investment has been recovered Decision Rule – Accept if the payback period is less than some preset limit.

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Payback Example You are looking at a new project and you have estimated the following cash flows (in dollars): Year 0: CF = -165,000 Year 1: CF = 63,120 Year 2: CF = 70,800 Year 3: CF = 91,080 Your required return for assets of this risk is 12%.
Example continued Assume we will accept the project if it pays back within two years. Year 1: 165,000 – 63,120 = 101,880 still to recover Year 2: 101,880 – 70,800 = 31,080 still to recover Year 3: 31,080 – 91,080 = -60,000 Project pays back during year 3. Payback = 2 years + 31,080/91,080 = 2.34 years Ratio is (how much is still needed to recover/CF the incremental year) Do we accept or reject the project?

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Disadvantages and Advantages The payback period method has major flaws: 1. Ignores all cash flow after the initial cash outflow has been recovered. 2. Ignores the time value of money. 3. Uses an arbitrary cut-off. Advantages include: 1. Easy to understand. 2. Useful when liquidity is a concern.
NPV Criteria Discounts all the cash flows from a project back to time 0 using an appropriate discount rate, r: A positive NPV implies that the project is adding value to the firm’s bottom line, Therefore, when comparing projects, the higher the NPV the better.

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