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10 Cards in this Set
- Front
- Back
Capital Budgeting techniques
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Discounted Cash Flow
Payback period Discounted Payback NPV IRR Capital rationing Profitability index |
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Discounted Cash Flow
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Formula - none
Advantage- considers time value of money Limitation- assumes simple constant growth ie single interest rate assumption |
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Payback period
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Net initial investment / Increase in annual net after - tax cash flow
Advantages- easy to use emphasis on liquidity Limitations- - time value of money ignored - cash flows after investment recovery not considered -total project profitability and reinvestment not considered. |
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Bailout payback period
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Includes salvage value in numerator
and therefore shortens payback period |
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Discounted Payback
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also called break even time method or BET
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Net present value
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= the PV of an investment's future net cash flows minus the initial investment.
-it assumes that positive cash flows are reinvested at the hurdle rate ( rate used in the analysis) thereby considering compounding of returns Accept -when NPV > 0 - then IRR<hurdle rate (RRR) Reject - when NPV< 0- then IRR > RRR (hurdle rate) Advantages- -flexible, more than one rate of interest - considered best method Limitation - does not give the true rate of return, just indicates if investment will earn hurdle rate - - |
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4 steps to calculate NPV
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1. Compute after tax cash flow= Pre-tax cash flow x (1- tax rate)
2. Add depreciation benefit = Depreciation x tax rate 3. Multiply result by appropriate present value of annuity. 4 Subtract initial Cash outflow (Investment) |
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Internal rate of return
OR Time adjusted rate of return |
determines present value factor that yields an NPV = 0
when IRR>hurdle (targeted RRR) rate Regect when IRR< or = hurdle (targeted) rate IRR> RRR when NPV =0 Limitations- - unreasonable reinvestment assumption at IRR rate -considers uniform cash flow -does consider amount of profit |
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NPV vs IRR methods
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NPV - highlights amounts, more conservative, assumes reinvestment @ hurdle rate
IRR - focuses decision makers on %, more aggressive, assumes reinvestment @ IRR, less reliable. NPV is superior to IRR as it is flexible enough to consistently handle either uneven cash flows or inconsistent rates of return for each year of the project. |
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Profitability index =
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(PV of cash flows) / Initial investment
If Profitability index > 1 then NPV > 0 It provides the means to rank capital projects w/ different amounts of investment |