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decisions Easy to understand
and May be useful when
funds are limited
funds Disadvantages May lead to incorrect
41 Capital Budgeting In Practice We should consider several investment
We criteria when making decisions
criteria NPV and IRR are the most commonly
used primary investment criteria
used Payback is a commonly used secondary
42 Summary – Discounted Cash Flow
Criteria Net present value Criteria Internal rate of return Difference between market value and cost
Take the project if the NPV is positive
Has no serious problems
Preferred decision criterion
Discount rate that makes NPV = 0
Take the project if the IRR is greater than the required return
Same decision as NPV with conventional cash flows
IRR is unreliable with non-conventional cash flows or mutually
exclusive Profitability Index Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital rationing 43
43 Summary – Payback Criteria Payback period Length of time until initial investment is recovered
Take the project if it pays back within some specified period
Doesn’t account for time value of money and there is an
arbitrary cutoff period
arbitrary Discounted payback period Length of time until initial investment is recovered on a
Take the project if it pays back in some specified period
There is an arbitrary cutoff period 44
44 Summary – Accounting
Criterion Average Accounting Return Measure of accounting profit relative to book
Similar to return on assets measure
Take the investment if the AAR exceeds some
specified return level
Serious problems and should not be used 45
45 Quick Quiz Consider an investment that costs $100,000 and has a
cash inflow of $25,000 every year for 5 years. The
required return is 9% and required payback is 4 years.
required What is the payback period?
What is the discounted payback period?
What is the NPV?
What is the IRR?
Should we accept the project? What decision rule should be the primary decision
When is the IRR rule unreliable? 46
46 9 End of Chapter 47...
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- Spring '14
- Net Present Value, Internal rate of return