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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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