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Capital Budgeting

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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.

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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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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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 ...

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