8 shorter payback periods are preferred the payback

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Unformatted text preview: 9.8. Shorter payback periods are preferred. The payback period’s strengths LG2 CHAPTER 9 Capital Budgeting Techniques 413 include ease of calculation, simple intuitive appeal, its consideration of cash flows, its implicit consideration of timing, and its ability to measure risk exposure. Its weaknesses include its lack of linkage to the wealth maximization goal, its failure to consider time value explicitly, and the fact that it ignores cash flows that occur after the payback period. compound annual rate of return that the firm will earn if it invests in a project and receives the given cash inflows. By accepting only those projects with IRRs in excess of the firm’s cost of capital, the firm should enhance its market value and the wealth of its owners. Both NPV and IRR yield the same accept–reject decisions, but they often provide conflicting ranks. Calculate, interpret, and evaluate the net present value (NPV). Because it gives explicit consideration to the time value of money, NPV is considered a sophisticated capital budgeting technique. The key formula and decision criteria for NPV are summarized in Table 9.8. In calculating NPV, the rate at which cash flows are discounted is often called the discount rate, required return, cost of capital, or opportunity cost. By whatever name, this rate represents the minimum return that must be earned on a project to leave the firm’s market value unchanged. Use net present value profiles to compare NPV and IRR techniques. A net present value profile is a graph that depicts the projects’ NPVs for various discount rates. It is useful in comparing projects, especially when NPV and IRR yield conflicting rankings. The NPV profile is prepared by developing a number of “discount rate–net present value” coordinates, often using discount rates of 0 percent, the cost of capital, and the IRR for each project, and then plotting them on the same set of discountrate–NPV axes. LG3 LG5 Discuss NPV and IRR in terms of conflicting rankings and the theoretical and practical strengths of each approach. Conflicting rankings of projects frequently emerge from NPV and IRR, as a result of differences in the magnitude and timing of each project’s cash flows. The underlying cause is the differing implicit assumptions of NPV and IRR LG6 Calculate, interpret, and evaluate the internal LG4 rate of return (IRR). Like NPV, IRR is a sophisticated capital budgeting technique because it explicitly considers the time value of money. The key formula and decision criteria for IRR are summarized in Table 9.8. IRR can be viewed as the TABLE 9.8 Summary of Key Formulas/Definitions and Decision Criteria for Capital Budgeting Techniques Technique Formula/definition Decision criteria Payback perioda For annuity: Accept if maximum acceptable payback period. Reject if maximum acceptable payback period. Initial investment Annual cash inflow For mixed stream: Calculate cumulative cash inflows on year-to-year basis until the initial investment...
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