Accounting Essay

974 WordsFeb 22, 20134 Pages
Capital Budgeting Techniques Chapter 8 Net Present Value and Other Investment Criteria • • • • • Net Present Value The Payback Rule The Average Accounting Return The Internal Rate of Return The Profitability Index Net Present Value • The difference between the market value of a project and its cost • How much value is created from undertaking an investment? – The first step is to estimate the expected future cash flows. – The second step is to estimate the required return for projects of this risk level. – The third step is to find the present value of the cash flows and subtract the initial investment. NPV Decision Rule • If the NPV is positive, accept the project • A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. • Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal. Payback Period • How long does it take to get the initial cost back in a nominal sense? • Computation – Estimate the cash flows – Subtract the future cash flows from the initial cost until the initial investment has been recovered Decision Criteria Test - Payback • Does the payback rule account for the time value of money? • Does the payback rule account for the risk of the cash flows? • Does the payback rule provide an indication about the increase in value? • Should we consider the payback rule for our primary decision criteria? • Decision Rule – Accept if the payback period is less than some preset limit Advantages and Disadvantages of Payback • Advantages – Easy to understand – Adjusts for uncertainty of later cash flows – Biased towards liquidity Average Accounting Return • There are many different definitions for average accounting return • The one used in the book is: – Average net income / average book value – Note that the

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