1 implies that for profitability every 1 of

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Unformatted text preview: identical decisions decisions Easy to understand Easy and communicate and May be useful when May available investment funds are limited funds Disadvantages May lead to incorrect May decisions in comparisons of mutually exclusive investments investments 41 41 Capital Budgeting In Practice We should consider several investment We criteria when making decisions criteria NPV and IRR are the most commonly NPV used primary investment criteria used Payback is a commonly used secondary Payback investment criteria investment 42 42 Summary – Discounted Cash Flow Summary 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 IRR exclusive projects 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 Doesn’t arbitrary cutoff period arbitrary Discounted payback period Length of time until initial investment is recovered on a Length discounted basis discounted Take the project if it pays back in some specified period There is an arbitrary cutoff period 44 44 Summary – Accounting Summary Criterion Criterion Average Accounting Return Measure of accounting profit relative to book Measure value value Similar to return on assets measure Take the investment if the AAR exceeds some Take specified return level specified Serious problems and should not be used 45 45 Quick Quiz Consider an investment that costs $100,000 and has a Consider 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 What method? method? When is the IRR rule unreliable? 46 46 9 End of Chapter 47...
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This document was uploaded on 03/01/2014 for the course FINANCE 250 at Indiana.

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