Module16 - Making the Decision for a Single Project...

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Making the Decision for a Single Project Considering Risk I Part I
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Key Concepts Last Module: Deterministic Evaluation of a Single Project This Module: Evaluation of a Single Project under Risk Estimates of future returns are uncertain and we must include that into our decision- making.
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Investment Risk Investing is risky! Money is invested in hopes of achieving returns later. But: Money invested may be lost. Returns may be less than expected. Returns may take too long to materialize. May have been better to invest elsewhere. This is called opportunity cost . Our measures of worth have no measure of risk.
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Payback Period A simple measure of the risk of a project: Identifies the first period in which you recover the outflows that generally occur at the beginning of an investment. Idea : if a project terminates before the payback period, you will not recover your investment. So, a short payback period is preferable. n * = min t A n 0 n = 0 t
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Example: Payback Period Constellation Energy Group Inc. (CEG) proposed to purchase a 70 MW wind farm in Maryland (with associated turbines) from Clipper Windpower for $140 million. CEG has a 20-year contract to sell the power to the Old Dominion Electric Coop. Sweet, C. “CORRECT: Constellation To Buy 70-MW Maryland Wind Farm From Clipper,” Dow Jones Business News , November 30, 2009.
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Solution If project does not last four years, $140 million will not be recovered.
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Pitfalls of the Payback Period 1. Does not include time-value-of money 2. Does not consider cash flows past time period n * 3. Does not provide a measure of worth or return Present Worth of previous example at 18% was $100.9 million.
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Positives of the Payback Period 1. Provides some measure of risk of a project -- unlike our measures of worth. 2. Can be used to enhance the evaluation of a project with a traditional measure of worth.
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Payback Period with Interest Same idea as the payback period, but interest is included in the definition: Now, we measure how long to recover the investment plus interest. n * = m in t A n n = 0 t 1 (1 + i ) n 0
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Example: Payback Period with Interest Use the data from the previous example but compute the payback period with interest.
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Solution With i >0, this number is always greater than or equal to the traditional payback period.
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As investments are risky, we prefer short payback periods because we will get our money back sooner. A project with a shorter payback period
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This note was uploaded on 01/11/2012 for the course EIN 4354 taught by Professor Tufecki during the Fall '08 term at University of Florida.

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Module16 - Making the Decision for a Single Project...

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