Capital Budgeting Techniques (1)

# Which can occur when there are irregular positive and

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which can occur when there are irregular positive and negative cash flows MIRR combines CFs until only one change in sign remains (see pg 174) MIRR model also addresses assumptions about the “reinvestment rate” for CF generated by the project

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Payback Criteria Payback is an ABSOLUTE \$\$\$ calculation Payback Period is the length of time (years/months) it takes for a project to generate CFs equal to the cost of the project Generally ignores TVM Generally ignores CF AFTER the payback period No absolute decision rule—Company sets standard 7
Discounted Payback Compares DISCOUNTED project CFs to the cost of the project Discounted Payback Period is the amount of time it takes DCFs to recover (COVER) the cost of the project Same Weaknesses Ignores CFs after payback Arbitrary standard 8

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Profitability Index Uses NPV data PI = PV of Inflows/PV of Outflows PI will be > 1 if project has positive NPV Most useful if Capital rationing constraints exist Strengths and Weaknesses: Initially ignores SCALE issues for MUTUALLY EXCLUSIVE projects Correct by using incremental analysis PI is effective ranking tool in CAPITAL RATIONING 9
Facts for Sample Problem Project A: Cost = 7500; Yr 1 CF = 4000, Yr 2 CF = 3500 Yr 3 CF= 1500 Project B: Cost = 5000; Yr 1 CF = 2500, Yr 2 CF = 1200, Yr 3 CF = 3000 Discount Factor BOTH Project = 15% 10

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Sample Problems 1. Project A: (INITIAL INVESTMENT = \$7500 ) Cumulative cash flows Year 1 = \$4,000 = \$4,000 Cumulative cash flows Year 2 = \$4,000 +3,500 = \$7,500 Payback period = 2 years Project B: (INITIAL INVESTMENT = \$ 5000 )
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