The Basics of Capital Budgeting: Payback Period Payback Period
Payback period was the earliest selection criterion.
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capital structure
financial statement
capital budgeting
The
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NPV
MIRR
IRR
payback
is a "break-even" calculation in the sense that if a project's cash flows come in at the expected rate, the project will break even. The equation is:
The
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shorter
longer
a project's payback, the better the project is. However, payback has 3 main disadvantages: (1) All dollars received in different years are given
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less
equal
more
weight. (2) Cash flows beyond the payback year are ignored. (3) The payback merely indicates when a project's investment will be recovered. There is no necessary relationship between a given payback and investor wealth maximization.
A variant of the regular payback is the discounted payback. Unlike regular payback, the discounted payback considers
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project
capital
overhead
costs. However, the discounted payback still disregards cash flows
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during
before
beyond
the payback year. In addition, there is no specific payback rule to justify project acceptance. Both methods provide information about
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profitability
wealth
liquidity
and risk.
Quantitative Problem: Bellinger Industries is considering two projects for inclusion in its capital budget, and you have been asked to do the analysis. Both projects' after-tax cash flows are shown on the time line below. Depreciation, salvage values, net operating working capital requirements, and tax effects are all included in these cash flows. Both projects have 4-year lives, and they have risk characteristics similar to the firm's average project. Bellinger's WACC is 7%.
0 1 2 3 4
Project A -1,000 700 450 290 340
Project B -1,000 300 385 440 790
What is Project A's payback? Round your answer to four decimal places. Do not round your intermediate calculations.
years
What is Project A's discounted payback? Round your answer to four decimal places. Do not round your intermediate calculations.
years
What is Project B's payback? Round your answer to four decimal places. Do not round your intermediate calculations.
years
What is Project B's discounted payback? Round your answer to four decimal places. Do not round your intermediate calculations.
years