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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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