Diff approaches for capital budgeting
- Created by: Shreeya Bhan
- Created on: 09-04-13 10:25
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- Different approaches for capital budgeting decisions
- Payback rule: Accept if the payback period (number of years required to recover a project’s initial cost back) is less than some preset limit
- Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive. (CF for 0 is negative cost)
- Provides an indication of a project’s risk and liquidityand Easy to calculate and understand
- Ignores the time value of money;Requires an arbitrary cutoff point; Ignores CFs occurring after the payback period
- Discounted Cash Flow: Accept the project if it pays back on a discounted basis within the specified time
- Compute the present value of each cash flow and then determine how long it takes to payback on a discounted basis
- Net Present value: If the NPV is positive, accept the project
- difference between the market value of a project and its cost (put negative cost in the CF0) - NPV = PV of inflows – Cost = Net gain in wealth
- Internal Rate of return: If IRR > k, (k is the opportunity cost) the project’s rate of return is greater than its costs. There is some return left over to boost stockholders’ returns
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- Payback rule: Accept if the payback period (number of years required to recover a project’s initial cost back) is less than some preset limit
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