Capital budgeting and decision making

Are mutually exclusive projects if the cash flows

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Unformatted text preview: are Mutually exclusive projects – if the cash flows Mutually of one can be adversely impacted by the acceptance of the other. acceptance Example Decision-making Criteria in Capital Budgeting Capital The ideal evaluation method should: a) include all cash flows (not accounting a) profits) that occur during the life of the profits) project (we will talk more in the next chapter), chapter), b) consider the time value of money, and b) time c) incorporate the required rate of return c) required (WACC remember?)on the project. (WACC on 6 Tools Payback period (PB). Discounted payback period (DPB). Net present value (NPV). Profitability Index (PI). Internal rate of return (IRR). Modified Internal rate of return (MIRR). Payback Period Payback How long will it take for the project How to generate enough cash to pay for itself? itself? Payback Period Payback How long will it take for the project How to generate enough cash to pay for itself? itself? (500) 0 150 150 150 150 150 150 150 1 2 3 4 5 6 7 150 8 Payback Period Payback How long will it take for the project How to generate enough cash to pay for itself? itself? (500) 0 150 150 150 150 150 150 150 1 2 3 4 5 6 7 Payback period = 3.33 years 150 8 Payback Period Is a 3.33 year payback period good? Is 3.33 Is it acceptable? Firms that use this method will compare Firms the payback calculation to some standard set by the firm. standard If our senior management had set a cutoff of 5 years for projects like ours, what off years would be our decision? would Accept the project. PB: More Ex. PB: Project L CFt Cumulative PaybackL Project S CFt Cumulative PaybackS 1 -100 -100 =2 = 2.4 3 60 -30 100 0 80 30 / 80 + 0 1.6 1 -100 -100 =1 = 2 10 -90 0 70 -30 + = 2.375 years 2 100 50 0 20 30 / 50 50 3 20 40 = 1.6 years Strengths of Payback: 1. Provides an indication of a project’s risk and liquidity. 2. Easy to calculate and understand. Weaknesses of Payback: 1. Ignores the TVM. 2. Ignores CFs occurring after the payback period. 3. Firm cutoffs are subjective. Drawbacks of Payback Period Drawbacks Does not consider all of the Does project’s cash flows. project’s (500) 0 150 150 150 150 150 150 150 1 2 3 4 5 6 7 Consider this cash flow stream! 150 8 Drawbacks of Payback Period Drawbacks Does not consider all of the project’s Does cash flows. cash (500) 0 150 150 150 150 150 150 150 1 2 3 4 5 6 7 This project is clearly unprofitable, but This we would accept it based on a 4-year accept payback criterion! payback 150 8 Discounted Payback Discounted Discounts the cash flows at the firm’s Discounts required rate of return. required Payback period is calculated using Payback these discounted net cash flows. these P...
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