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lec 9 capital budgeting, ranking problems - Coggle Diagram
lec 9 capital budgeting
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payback method
- number of years required to recover a project's cost. "how long it will take to payback or recover the initial investment
- calculate by adding project's CF to its cost
- decision rules:
- PP: payback period
- MDPP: maximize desired payback period
- independent projects:
- PP <= MDPP - accept
- PP > MDPP - reject
- mutually exclusive projets:
select the project with the faster payback, PP <= MDPP
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rationale for the NPV method:
NPV = PV of inflows - cost = Net gain in wealth
- independent project accept if NPV > 0
- mutually exclusive, accept the highest positive NPV
pros and cons of payback
- strengths
- indicate project's risk and liquidity
- easy calculate and understand
- weakness
- merely a number
- ignores time value money
- ignores CFs occurring after payback period.
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ranking problems
- when NPV = 0, IRR = k
- when NPV > 0, IRR > k
- when NPV < 0, IRR < k
no capital rationing + independent project, NPV and IRR method always same accept/reject
mutually exclusive projects and/or capital rationing ranking problem occur when
- initial investments differ
- time of FCF differ
- NPV: assume reinvestment of FCF at cost of capital
- IRR: assume reinvestment of FCF at project's IRR
=> NPV method maximize the value of the firm (firm value)