Finance 2.doc - A capital budgeting decision is both a...

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A capital budgeting decision is both a financial commitment and an investment. By taking on a project, thebusiness is making a financial commitment, but it is also investing in its longer-term direction that will likelyhave an influence on future projects the company considers.Different businesses use different valuation methods to either accept or reject capital budgeting projects.Although the net present value (NPV) method is the most favorable one among analysts, the internal rate ofreturn (IRR) and payback period (PB) methods are often used as well under certain circumstances. Managerscan have the most confidence in their analysis when all three approaches indicate the same course of action.When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether or notthe project will prove to be profitable. The payback period (PB), internal rate of return (IRR) and net presentvalue (NPV) methods are the most common approaches to project selection.The following below are some of the financial indicators in making investment decisions:1.payback periodThe payback period calculates the length of time required to recoup the original investment. For example, if acapital budgeting project requires an initial cash outlay of $1 million, the PB reveals how many years arerequired for the cash inflows to equate to the one million dollar outflow. A short PB period is preferred as itindicates that the project would "pay for itself" within a smaller time frame.Payback periods are typically used when liquidity presents a major concern. If a company only has a limitedamount of funds, they might be able to only undertake one major project at a time. Therefore, managementwill heavily focus on recovering their initial investment in order to undertake subsequent projects.Another major advantage of using the PB is that it is easy to calculate once the cash flow forecasts have beenestablished. There are drawbacks to using the PB metric to determine capital budgeting decisions. Firstly, thepayback period does not account for the time value of money (TVM). Simply calculating the PB provides ametric that places the same emphasis on payments received in year one and year two.Such an error violates one of the fundamental principles of finance. Luckily, this problem can easily beamended by implementing a discounted payback period model. Basically, the discounted PB period factors in

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Term
Fall
Professor
lamin touray

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