Capital Budgeting Criteria Payback Payback analysis in 5 easy steps Step 1 Find

# Capital budgeting criteria payback payback analysis

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Capital Budgeting Criteria: Payback Payback analysis in 5 easy steps Step 1: Find the outlay, which is the amount of cash that must be recovered (equals -C 0 in FNAN 301/303) Step 2: compute expected CF needed after 1 year to reach payback (equals outlay minus C 1 ) If zero, then payback period is exactly 1 year Go to step 5 (decide whether to invest or not) If negative, then more CF than needed for payback is expected in year 1 and payback period is between 0 and 1 year Go to step 4 (find the payback period when it is “mid-year”) If positive, then insufficient expected CF is expected by the end of year 1 for payback, so payback period is greater than 1 year Go to step 3 Step 3: repeat step 2 for each year (starting with year 2) to reach payback until either payback is reached or all years in the project have been analyzed
dgeting criteria - 38 Capital Budgeting Criteria: Payback Payback analysis in 5 easy steps Step 4: find the payback period when it is “mid-year” The project is expected to reach payback between t and t+1 years if Not enough cumulative CF for payback is expected at time t More cumulative CF than needed for payback is expected at yr t+1 Assume that the expected cash flow produced by a project for a given year is produced at a uniform rate throughout the year The portion of year t+1 that it will take to produce the cash needed for payback is Expected CF needed for payback after t yrs / expected CF in yr t+1 The payback period is t + (the portion of year t+1 that it will take to produce the cash needed for payback)
dgeting criteria - 39 Capital Budgeting Criteria: Payback Payback analysis in 5 easy steps Step 5: decide whether to invest or not Accept project if the payback period is less than or equal to the limit set by the firm Reject project if the payback period is greater than the limit set by the firm
dgeting criteria - 40 Capital Budgeting Criteria: Payback – Example Year Expected cash flow (CF) during year Present value of expected CF during year Project expected CF needed after end of year = project expected CF needed after end of previous year minus expected CF during year 0 -1,650 Not relevant for payback period (but will be for discounted payback period) 1 650 2 700 3 900 Tables are very useful when computing payback (and discounted payback) Project Z
dgeting criteria - 41 Capital Budgeting Criteria: Payback – Example Year Expected cash flow (CF) during year Present value of expected CF during year Project expected CF needed after end of year = project expected CF needed after end of previous year minus expected CF during year 0 -1,650 Not relevant for payback period 1,650 1 650 1,650 – 650 = 1,000 2 700 3 900 Project Z
dgeting criteria - 42 Capital Budgeting Criteria: Payback – Example Year Expected cash flow (CF) during year Present value of expected CF during year Project expected CF needed after end of year = project expected CF needed after end of previous year minus expected CF during year 0 -1,650 Not relevant for payback period 1,650 1 650 1,650 – 650 = 1,000 2 700 1,000 – 700 = 300 3 900 300 – 900 = -600