Diff approaches for capital budgeting

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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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