UT FIN 357 - Chapter 7. Investment Decision Rules v2 (36 pages)

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Chapter 7. Investment Decision Rules v2



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Chapter 7. Investment Decision Rules v2

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Pages:
36
School:
University of Texas at Austin
Course:
Fin 357 - Business Finance

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Investment Decision Rules J David Miller 2017 Chapter 7 Finance 357 NPV Rule NPV discounts cash flows to period 0 and then compares them Accept a project if the NPV is 0 Reject a project if the NPV is 0 Accepting positive NPV projects benefits stockholders by creating wealth The value of the firm rises by the NPV of the project 2 Are Alternatives to NPV good Benefits of NPV 1 NPV uses cash flow 2 NPV uses all cash flows of a project 3 NPV discounts cash flows properly TVM Alternative methods Payback Period Discounted Payback Period Average Accounting Return Internal Rate of Return Profitability Index 3 Payback Period Method The Payback Period Method of capital budgeting is interested in how long it takes for a project to bring in enough cash flows to break even or pay itself off A rule is set to determine the maximum time allowed for projects to pay themselves back 4 Year Cash Flow 0 10 000 1 5 000 2 5 000 3 5 000 Payback Period Method Year Cash Flow Paid Back 0 10 000 1 5 000 5 000 2 5 000 10 000 3 5 000 In this project it takes 2 years to repay the original 10 000 spent on the project 5 Payback Period Rule The payback period rule states that all projects must be paid back before a particular cutoff date This date is arbitrary and up to management to select 6 Payback Period Example Alpha Inc is considering a project with the following cash flows Alpha Management has decided that all projects must pay themselves back within 3 years Using the Payback Period Method should Alpha accept this project 7 Year Cash Flow 0 125 000 1 5 000 2 90 000 3 20 000 4 100 000 5 100 000 Payback Period Example Alpha Inc is considering a project with the following cash flows Alpha Management has decided that all projects must pay themselves back within 3 years Using the Payback Period Method should Alpha accept this project Year Cash Flow Paid Back 0 125 000 1 5 000 5 000 2 90 000 95 000 3 20 000 115 0000 4 100 000 5 100 000 After 3 years only 115 000 is repaid The project should not be



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