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Capital Budgeting - Payback, NPV, PI, IRR

Can someone please describe the following project evaluation processes for me: Payback, NPV, PI, IRR. Is any one evaluation process better the others? Why?

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Can someone please describe the following project evaluation processes for me: Payback, NPV, PI, IRR. Is any one evaluation process better the others? Why?

Project appraisal methods are:

? Traditional methods:
Payback Period method
Accounting rate of return method

? Discounted Cash flow (DCF) methods:
NPV (Net Present Value) method
IRR (Internal Rate of Return) method
Profitability index

A) Payback Period:

Payback time or payback period is the time it will take to recoup, in the form of cash inflows from operations, the initial amount invested in a project. The shorter the payback period, the better it is. To apply the payback period criterion, it is necessary for management to establish a maximum acceptable payback value PP*. In practice, PP* is usually between 2 and 4 years.

In determining whether to accept or reject a particular project, the payback period decision rule is:
Accept if PP < PP*
Reject if PP > PP*
Indifferent where PP = PP*

For mutually exclusive alternatives accept the project with the lowest PP if PP<PP*

To calculate the Payback Period:
? If the cash flows are an annuity, then we can simply divide the cost by the annual cash flow to determine the payback period
? Otherwise, we calculate the cumulative cash flow and note when it becomes positive.

Example 1: A firm is considering the purchase of a new machine that will cost $ 70,000 and last five years. The machine will increase profits by $20,000 per year. Calculate the payback period.

Since the cash flow is an annuity,
Payback period = $70,000 / $20,000 = 3.5 years

Example 2: Suppose the cash flow for a project is as follows:

Initial investment = $10,000
Year 1-5 cash inflows:

Year Cash flow
1 $2,000
2 $2,500
3 $3,000
4 $3,500
5 $4,000

Calculate the payback period.

The cash flow is not an annuity, therefore we employ a different method. We calculate the cumulative cash flow.

Year Cash flow Cumulative cash flow

0 (10,000) (10,000)
1 2,000 (8,000)
2 2,500 ...

Solution Summary

The project evaluation techniques for capital budgeting-Payback, NPV, PI, IRR,P rofitability Index (PI)- are discussed.

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