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BUS FP3062 McAndrewVanessa Assessment9 Attempt1

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Running head: CAPITAL BUDGETING TECHNIQUES 1
Capital Budgeting Techniques
Vanessa McAndrew
Capella University

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CAPITAL BUDGETING TECHNIQUES 2
Net present value (NPV)
Net Present Value method for project evaluation was developed to counter the flaws in
payback period. It relies on discounted cash flows (DCF) techniques. To implement this method,
we proceed as follows:
First, we find the present value of each cash flow, including both inflows and outflows,
discounted at the project’s cost of capital. Secondly, we sum these discounted cash flows; this
sum is defined as the project’s NPV. If the NPV is positive, the project should be accepted, while
if the NPV is negative, it should be rejected. If two projects with positive NPV are mutually
exclusive, the one with the higher NPV should be chosen (Storesletten, 2003).
Payback period statistic.
Payback on a project is a measure of how quickly the cash flows generated by the project cover
the initial investment. This was the first formal method used to evaluate capital budgeting
projects. Intuitively, projects that return their investment sooner can be considered more
attractive projects since all cash flows earned beyond that point in time can be considered as
profit on the project. Such projects can be considered as less risky. It provides an indication of a
project’s risk and liquidity. Hence, the acceptance benchmark when using this statistic is that the
payback period should be as soon as possible and less than the life of the project (Ross, 2002).
Internal rate of return (IRR)
IRR is defined as that discount rate which equates the present value of a project’s expected
cash flows to the present value of the project’s costs. In other words, internal rate of return is the
discount rate which forces a project’s NPV to equal to zero. It is the rate which equates the PV of
cash inflows to PV of cash outflows. The project is accepted if the IRR is greater than the cost of
capital (Kelleher, 2004) .

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Running head: CAPITAL BUDGETING TECHNIQUES Capital Budgeting Techniques Vanessa McAndrew Capella University 1 CAPITAL BUDGETING TECHNIQUES 2 Net present value (NPV) Net Present Value method for project evaluation was developed to counter the flaws in payback period. It relies on discounted cash flows (DCF) techniques. To implement this method, we proceed as follows: First, we find the present value of each cash flow, including both inflows and outflows, discounted at the project’s cost of capital. Secondly, we sum these discounted cash flows; this sum is defined as the project’s NPV. If the NPV is positive, the project should be accepted, while if the NPV is negative, it should be rejected. If two projects with positive NPV are mutually exclusive, the one with the higher NPV should be chosen (Storesletten, 2003). Payback period statistic. Payback on a project is a measure of how quickly the cash flows generated by the project cover the initial investment. This was the first formal method used to evaluate capital budgeting projects. Intuitively, projects that return their investment sooner can be considered more attractive projects since all cash flows earned beyond that point in time can be considered as profit on the project. Such projects can be considered as less risky. It provides an indication of a project’s risk and liquidity. Hence, the acceptance benchmark when using this statistic is that the payback period should be as soon as possible and less than the ...
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