3 - 3. a. Payback period is like a break-even point of...

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3. a. Payback period is like a break-even point of future cash flows. It is calculated as continuous rate, not a single point of time. The payback period is biased towards short-term projects; it fully ignores any cash flows that occur after the cutoff point. Accept the lowest payback period. b. At the IRR discount rate, the net value of the project is zero. If C 0 < 0 and all future cash flows are positive, accept the project if the IRR is greater than or equal to the discount rate. If C 0 < 0 and all future cash flows are positive, reject the project if the IRR is less than the discount rate. If C 0 > 0 and all future cash flows are negative, accept the project if the IRR is less than or equal to the discount rate. c. The profitability index is the present value of cash inflows relative to the project cost. Accept if PI>1. d. NPV is simply the present value of a project’s cash flows. Accept positive, highest NPV. 9. Although the profitability index (PI) is higher for Project B than for Project A, Project A should be chosen because it has the greater NPV. 11. Project B’s NPV would be more sensitive to changes in the discount rate. The reason is the time value of money. Cash flows that occur further out in the future are always more sensitive to changes in the interest rate. This sensitivity is similar to the interest rate risk of a bond. Problem: 1. a. A: Cumulative cash flows Year 1 = $6,500 = $6,500 Cumulative cash flows Year 2 = $6,500 + 4,000 = $10,500 Payback period = 1 + ($10,000 – $6,500) / $4,000 Payback period = 1.875 years B: Cumulative cash flows Year 1 = $7,000
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This note was uploaded on 02/27/2012 for the course BUSI 407 taught by Professor Bowen during the Spring '11 term at UNC.

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3 - 3. a. Payback period is like a break-even point of...

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