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Capital Budgeting

What are the three potential flaws with the regular payback method? Does the discounted payback method correct all three flaws? Explain.

Why is the NPV of a relatively long-term project (one for which a high percentage of its cash flows occurs in the distant future) more sensitive to changes in WACC than that of a short-term project?

What is a mutually exclusive project? How should managers rank mutually exclusive projects?

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What are the three potential flaws with the regular payback method? Does the discounted payback method correct all three flaws? Explain.

Flaw #1 - Timing of Cash Flows within the Payback Period. The payback method does not consider the timing of cash flows within the payback period. Thus, the payback method is second-rate to NPV because the NPV method discounts the cash flows PROPERLY (where as the payback method does not). Flaw #2 - Payments After the Payback Period. The payback method ignores all cash flows occurring after the payback period. Because of the short-term orientation of the payback method, some valuable long-term projects are likely to be ...

Solution Summary

This solution describes three potential flaws with the regular payback method and how the discounted payback method compares. It further explains the senstivities of long-term projects and mutually exclusive projects.

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