9 19 comparing npv and payback period time project a

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Unformatted text preview: ing NPV and Payback period Time Project A Project B • Compute the payback 0 -250 -250 period and the NPV 1 100 100 given for the two 2 100 200 projects with cash 3 100 0 flows shown. Use a 4 100 0 discount rate of 15% and an acceptable payback period of 2 years or less. 9-19 Comparing NPV and Payback period Time Project A Project B 0 -250 -250 1 100 100 2 100 200 3 100 0 4 100 0 • Answer: • Payback is 3 years for project A, so it should be rejected by this method. Payback is 2 years for project B, so it should be accepted with this method. • Using 15%, NPV is 35.50 for project A, so it should be accepted by this method. NPV is -11.81 for project B, so it should be rejected using this method. • So the two methods give conflicting results. 9-20 Advantages and Disadvantages of Payback period rule • Advantages • Easy to understand – simple rule of thumb • Adjusts for uncertainty of later cash flows • Biased towards liquidity, meaning that it is more likely to accept those projects that frees up cash quickly • Disadvantages • Ignores the time value of money • Requires an arbitrary cutoff point • Ignores cash flows beyond the cutoff date • Biased against longterm projects, such as research and development, and new projects 9-21 Decision Criteria Test - Payback • Does the payback rule account for the time value of money? no • Does the payback rule account for the risk of the cash flows? no • Does the payback rule provide an indication about the increase in value? no • The answer to all of these questions is no. 9-22 Discounted Payback Period • Variation on the payback period rule • Takes into account the time value of money • Compute the present value of each cash flow and then determine how long it takes to payback on a discounted basis • Compare to a specified required payback period • Decision Rule - Accept the project if it pays back on a discounted basis within the specified time 9-23 Computing Discounted Payback for the Project • Accept the project if it pay...
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This document was uploaded on 02/06/2014.

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