# Capital budgeting criteria 36 lecture problems 6 i

• kvk95951
• 60

This preview shows page 34 - 41 out of 60 pages.

Capital budgeting criteria - 36Lecture Problems 6I Scream Ice Cream is considering a project that is expected to cost \$500,000 today and produce cash flows of \$170,000 in 1 year, \$200,000 in 2 years, \$250,000 in 3 years, \$100,000 in 4 years; and -\$150,000 in 5 years.Should I Scream use IRR to evaluate this project?
Capital budgeting criteria - 38FNAN 303 NotesOur coverage of payback method focuses on projects with conventional cash flowsMethod can be modified to account for projects having other patterns of expected cash flows
Capital budgeting criteria - 39Capital Budgeting Criteria: PaybackPayback analysis in 5 easy stepsStep 1: Find the investment, which is the amount of cash that must be recovered (equals -C0with conventional CFs)Step 2: compute expected CF needed after 1 year to reach payback (equals investment minus C1)If zero, then payback period is exactly 1 yearGo 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 yearGo 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 yearGo to step 3 (repeat step 2 as long as needed)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
Capital budgeting criteria - 40Capital Budgeting Criteria: PaybackPayback analysis in 5 easy stepsStep 4: find the payback period when it is “mid-year”The project is expected to reach payback between t and t+1 yrs ifNot enough cumulative CF for payback is expected by year tMore cumulative CF than needed for payback is expected by year t+1Assume 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 isExpected CF needed for payback after t years / expected CF in year t+1 The payback period is t + (the portion of year t+1 that it will take to produce the cash needed for payback)tt+1paybackExpected CF needed for payback after t yearsExpected CF in year t+1
Capital budgeting criteria - 41Capital Budgeting Criteria: PaybackPayback analysis in 5 easy stepsStep 5: decide whether to invest or notAccept project if the payback period is less than or equal to the limit set by the firmReject project if the payback period is greater than the limit set by the firm
Capital budgeting criteria - 42