Value does the payback rule account for the risk of

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Unformatted text preview: ule provide an indication Does about the increase in value? about Should we consider the payback rule for our Should primary decision rule? primary 13 13 Advantages and Disadvantages Advantages of Payback of Advantages Easy to understand Adjusts for uncertainty Adjusts of later cash flows of Biased toward liquidity Disadvantages Ignores the time value Ignores of money of Requires an arbitrary Requires cutoff point cutoff Ignores cash flows Ignores beyond the cutoff date beyond Biased against longterm projects, such as term research and development, and new projects projects 14 14 Discounted Payback Period Compute the present value of each cash flow Compute and then determine how long it takes to pay back on a discounted basis back Compare to a specified required period Decision Rule - Accept the project if it pays Decision back on a discounted basis within the specified time specified 15 15 Computing Discounted Payback for Computing the Project the Assume we will accept the project if it pays back on a Assume discounted basis in 2 years. discounted Compute the PV for each cash flow and determine the Compute payback period using discounted cash flows payback Year 1: 165,000 – 63,120/1.121 = 108,643 Year 2: 108,643 – 70,800/1.122 = 52,202 Year 3: 52,202 – 91,080/1.123 = -12,627 project pays back in year 3 year Do we accept or reject the project? 16 16 Decision Criteria Test – Discounted Decision Payback Payback Does the discounted payback rule account for the time Does value of money? value Does the discounted payback rule account for the risk Does of the cash flows? of Does the discounted payback rule provide an indication Does about the increase in value? about Should we consider the discounted payback rule for Should our primary decision rule? our 17 17 Advantages and Disadvantages of Advantages Discounted Payback Discounted Advantages Includes time value of Includes money money Easy to understand Does not accept Does negative estimated NPV investments when all future cash flows are positive flows Biased towards Biased liquidity liquidity Disadvantages May reject positive May NPV investments NPV Requires an arbitrary Requires cutoff point cutoff Ignores cash flows Ignores beyond the cutoff point beyond Biased against longterm projects, such as term R&D and new products products 18 18 Average Accounting Return There are many different definitions for average There accounting return accounting The one used in the book is: Average net incom...
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