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    Exclusive Projects.: Project Classifications

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    ammar123
    The document discusses different methods for classifying and evaluating capital budgeting projects. It describes two types of projects: independent projects, whose cash flows are unaffected by other projects, and mutually exclusive projects, where at most one project can be selected from a set of alternatives. It then explains three capital budgeting decision rules - payback period, net present value (NPV), and internal rate of return (IRR). The payback period considers cash flows up until the payback point, while NPV and IRR incorporate the time value of money by discounting all cash flows. NPV measures a project's overall profitability while IRR is the discount rate that produces an NPV of zero. The document provides examples of calculating

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    Exclusive Projects.: Project Classifications

    Uploaded by

    ammar123
    47 views4 pages
    The document discusses different methods for classifying and evaluating capital budgeting projects. It describes two types of projects: independent projects, whose cash flows are unaffected by other projects, and mutually exclusive projects, where at most one project can be selected from a set of alternatives. It then explains three capital budgeting decision rules - payback period, net present value (NPV), and internal rate of return (IRR). The payback period considers cash flows up until the payback point, while NPV and IRR incorporate the time value of money by discounting all cash flows. NPV measures a project's overall profitability while IRR is the discount rate that produces an NPV of zero. The document provides examples of calculating

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    The document discusses different methods for classifying and evaluating capital budgeting projects. It describes two types of projects: independent projects, whose cash flows are unaffected by other projects, and mutually exclusive projects, where at most one project can be selected from a set of alternatives. It then explains three capital budgeting decision rules - payback period, net present value (NPV), and internal rate of return (IRR). The payback period considers cash flows up until the payback point, while NPV and IRR incorporate the time value of money by discounting all cash flows. NPV measures a project's overall profitability while IRR is the discount rate that produces an NPV of zero. The document provides examples of calculating

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    47 views4 pages

    Exclusive Projects.: Project Classifications

    Uploaded by

    ammar123
    The document discusses different methods for classifying and evaluating capital budgeting projects. It describes two types of projects: independent projects, whose cash flows are unaffected by other projects, and mutually exclusive projects, where at most one project can be selected from a set of alternatives. It then explains three capital budgeting decision rules - payback period, net present value (NPV), and internal rate of return (IRR). The payback period considers cash flows up until the payback point, while NPV and IRR incorporate the time value of money by discounting all cash flows. NPV measures a project's overall profitability while IRR is the discount rate that produces an NPV of zero. The document provides examples of calculating

    Copyright:

    © All Rights Reserved
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    Download as pdf or txt
    of 4

    Ihtisham Jadoon

    Financial Management
    [email protected]
    Cell: 0313-5937627
    Project Classifications
    Capital Budgeting projects are classified as either Independent Projects or Mutually
    Exclusive Projects.
    An Independent Project is a project whose cash flows are not affected by the
    accept/reject decision for other projects. Thus, all Independent Projects which meet the
    Capital Budgeting criterion should be accepted.
    Mutually Exclusive Projects are a set of projects from which at most one will be
    accepted. For example, a set of projects which are to accomplish the same task. Thus,
    when choosing between "Mutually Exclusive Projects" more than one project may satisfy
    the Capital Budgeting criterion. However, only one, i.e., the best project can be accepted.

    Capital Budgeting is the process by which the firm decides which long-term investments
    to make. Capital Budgeting projects, i.e., potential long-term investments, are expected to
    generate cash flows over several years. The decision to accept or reject a Capital
    Budgeting project depends on an analysis of the cash flows generated by the project and
    its cost

    The following three Capital Budgeting decision rules will be presented:
    Payback Period
    Net Present Value (NPV)
    Internal Rate of Return (IRR)
    A Capital Budgeting decision rule should satisfy the following criteria:
    Must consider all of the project's cash flows.
    Must consider the Time Value of Money
    Must always lead to the correct decision when choosing among Mutually
    Exclusive Projects.

    Payback Period
    The Payback Period represents the amount of time that it takes for a Capital
    Budgeting project to recover its initial cost. The use of the Payback Period as a Capital
    Budgeting decision rule specifies that all independent projects with a Payback Period less
    than a specified number of years should be accepted. When choosing among mutually
    exclusive projects, the project with the quickest payback is preferred.


    Ihtisham Jadoon
    Financial Management
    [email protected]
    Cell: 0313-5937627
    Advantages:
    Easy to calculate and understand
    Provides and indication of a project's risk and liquidity

    Disadvantages:
    Ignores time value of money - to correct for this disadvantage the discounted
    payback period can be used. The discounted payback period is an improvement
    over the regular payback method because the present value (discounted) of the
    project's cash flows is used to calculate the payback period. The discounted
    payback method considers the time value of money.
    Does not consider cash flows occurring after the payback period



    Net Present Value
    The Net Present Value (NPV) of a Capital Budgeting project indicates the expected
    impact of the project on the value of the firm. Projects with a positive NPV are expected
    to increase the value of the firm. Thus, the NPV decision rule specifies that
    all independent projects with a positive NPV should be accepted. When choosing
    among mutually exclusive projects, the project with the largest (positive) NPV should be
    selected.
    The NPV is calculated as the present value of the project's cash inflows minus the present
    value of the project's cash outflows. This relationship is expressed by the following
    formula:

    Where
    CF
    t
    = the cash flow at time t and
    r = the cost of capital.
    The example below illustrates the calculation of Net Present Value. Consider Capital
    Budgeting projects A and B which yield the following cash flows over their five year
    lives. The cost of capital for the project is 10%.
    Ihtisham Jadoon
    Financial Management
    [email protected]
    Cell: 0313-5937627
    Project A Project B
    Year
    Cash
    Flow
    Cash
    Flow
    0 $-1000 $-1000
    1 500 100
    2 400 200
    3 200 200
    4 200 400
    5 100 700
    Net Present Value
    Project A:


    Project B:

    Advantages:
    Considers time value of money
    Considers all cash flows
    NPV is the value the project will add to the firm
    Considered to be the best decision criteria
    Disadvantages:
    NPV will be erroneous if cash flow estimates are incorrect (requires accurate cash
    flow estimations)
    NPV is a dollar return but percent returns are easier to communicate and
    understand
    Internal Rate of Return
    The Internal Rate of Return (IRR) of a Capital Budgeting project is the discount rate at
    which the Net Present Value (NPV) of a project equals zero. The IRR decision rule
    specifies that all independent projects with an IRR greater than the cost of capital should
    Ihtisham Jadoon
    Financial Management
    [email protected]
    Cell: 0313-5937627
    be accepted. When choosing among mutually exclusive projects, the project with the
    highest IRR should be selected (as long as the IRR is greater than the cost of capital).

    For a given project, the NPV and IRR will give the same accept/reject decision. In
    other words, if the NPV > 0, then IRR > k; or if the NPV = 0, then IRR = k; or if
    NPV<0, then IRR<k.

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