A Comparison of Capital Budgeting Techniques Capital budgeting ...
A Comparison of Capital Budgeting Techniques Capital budgeting ...
A Comparison of Capital Budgeting Techniques Capital budgeting ...
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<strong>Capital</strong> <strong>Budgeting</strong> <strong>Techniques</strong><br />
A collection <strong>of</strong> methods allowing the manager to choose among a variety <strong>of</strong> investment projects.<br />
Methods:<br />
• Average Accounting Return<br />
• Payback<br />
• Discounted payback<br />
• Internal Rate <strong>of</strong> Return<br />
• Modified Internal Rate <strong>of</strong> Return<br />
• Net Present Value<br />
• Pr<strong>of</strong>itability Index<br />
Average Accounting Return (AAR)<br />
AAR is the ratio <strong>of</strong> the Average Net Income to the Average Book Value.<br />
Decision rule: Take the project if AAR is greater than some target ratio set by accountants.<br />
Disadvantages: It has too many flaws, don't ever use it.<br />
Payback period<br />
Payback is the time it takes to recover the initial cost <strong>of</strong> the investment. Payback is usually measured in<br />
years.<br />
Decision rule: Take the project with the shortest payback period<br />
Disadvantages<br />
It ignores time value <strong>of</strong> money<br />
It ignores risk<br />
It ignores cash inflows beyond the cut<strong>of</strong>f point<br />
Project A: Payback calculation<br />
Period Cash flow Amount left to recover<br />
0 -$5,045.00 -$5,045.00<br />
1 $400 $4,645.00<br />
2 $1,250 $3,395.00<br />
3 $900.00 $2,495.00<br />
0.83 $3,000.00 $0.00<br />
Notice that in the fourth year, there is $2,495 left to recuperate, and the annual cash flow equals $3,000<br />
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