dgeting criteria - 78Finance-tutor projectYearExpected cash flow (CF) during yearPresent value of expected CF during year(r = 12%)Project expected DCF needed after end of year = project expected DCF needed after end of previous year minus expected DCF during year0-1,650-1,6501,6501650650/1.12 = 580.361,650 – 580.36 = 1,069.642700700/1.122 = 558.041,069.64 – 558.04 = 511.603900900/1.123 = 640.60511.60 – 640.60 = -129.00We see that discounted payback is between the end of years 2 and 3After 2 years, 511.60 in expected discounted cash flows are neededIn year 3, expected discounted cash flows are 640.60Capital Budgeting Criteria:Discounted Payback – Example

dgeting criteria - 79Finance-tutor projectYearExpected cash flow (CF) during yearPresent value of expected CF during year(r = 12%)Project expected DCF needed after end of year = project expected DCF needed after end of previous year minus expected DCF during year0-1,650-1,6501,6501650650/1.12 = 580.361,650 – 580.36 = 1,069.642700700/1.122 = 558.041,069.64 – 558.04 = 511.603900900/1.123 = 640.60511.60 – 640.60 = -129.00We see that discounted payback is between the end of years 2 and 3After 2 years, 511.60 in expected discounted cash flows are neededIn year 3, expected discounted cash flows are 640.60Assume expected discounted cash flows occur uniformly throughout the yearThus, it would take (511.60/640.60) = 0.80 of year 3 to reach discounted paybackDiscounted payback period = 2 + 0.80 = 2.80 yearsCapital Budgeting Criteria:Discounted Payback – Example

dgeting criteria - 80Capital Budgeting Criteria:Discounted Payback – ExampleÜIf Patriot Theaters believes that opening a Boston multiplex would cost $550,000 today and would produce cash flows of $100,000, $200,000, $300,000, and $400,000 in 1, 2, 3, and 4 years, would the firm choose to expand, based on discounted payback, if the cost of capital associated with the project is 23.4 percent and the discounted payback limit is 3.4 years?YearExpected cash flow (CF) during yearPresent value of expected CF during year (r = 23.4%)Project expected DCF needed after end of year = project expected DCF needed after end of previous year minus expected DCF during year0-550,000-550,000550,0001100,000100k/1.234 = 81,037550,000 – 81,037 = 468,9632200,000200k/1.2342 = 131,341468,963 – 131,341 = 337,6223300,000300k/1.2343 = 159,653337,622 – 159,653 = 177,9694400,000400k/1.2344 = 172,504177,969 – 172,504 = 5,465Discounted payback never takes placeDiscounted payback period = ∞ > 3.4 years, so do not pursue the project

dgeting criteria - 81Lecture Problems 10ÜI Scream Ice Cream is considering a project that is expected to cost $500,000 today; produce cash flows of $170,000 in 1 year, $200,000 in 2 years, $250,000 in 3 years, and $100,000 in 4 years; and have a cost of capital of 9 percentèWould the firm accept the project based on discounted payback if the firm accepts projects with a discounted payback period of 2.4 years or less?

dgeting criteria - 82Capital Budgeting Criteria:Discounted PaybackÜKey strengths of discounted payback and the discounted payback rule that are not strengths of paybackèRecognizes the time value of moneyèRecognizes project risk (at least partially by incorporating cost of capital)èFor projects with conventional cash flows, negative NPV projects will not be accepted•Discounted payback period is infinity§Sum of the present value of all expected cash flows produced by project is less than the investment, so discounted payback never takes place

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