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- 1. Advantage and disadvantages of the different capital budgetingtechniquesPrepared by Pamela Peterson-Drake, Florida Atlantic UniversityPayback PeriodAdvantages Disadvantages 1. Simple to compute 1. No concrete decision criteria to indicate 2. Provides some information on the risk whether an investment increases the firms of the investment value 3. Provides a crude measure of liquidity 2. Ignores cash flows beyond the payback period 3. Ignores the time value of money 4. Ignores the risk of future cash flowsDiscounted Payback PeriodAdvantages Disadvantages 1. No concrete decision criteria that indicate whether the investment increases the firms 1. Considers the time value of money value 2. Considers the riskiness of the projects 2. Requires an estimate of the cost of capital in cash flows (through the cost of capital) order to calculate the payback 3. Ignores cash flows beyond the discounted payback periodNet Present ValueAdvantages Disadvantages 1. Tells whether the investment will increase he firms value 1. Requires an estimate of the cost of capital 2. Considers all the cash flows in order to calculate the net present value. 3. Considers the time value of money 2. Expressed in terms of dollars, not as a 4. Considers the risk of future cash flows percentage. (through the cost of capital)
- 2. Profitability IndexAdvantages Disadvantages 1. Tells whether an investment increases the firms value 2. Considers all cash flows of the project 1. Requires an estimate of the cost of capital in 3. Considers the time value of money order to calculate the profitability index 4. Considers the risk of future cash flows 2. May not give the correct decision when used (through the cost of capital) to compare mutually exclusive projects. 5. Useful in ranking and selecting projects when capital is rationedInternal Rate of ReturnAdvantages Disadvantages 1. Tells whether an investment increases 1. Requires an estimate of the cost of capital in the firms value order to make a decision 2. Considers all cash flows of the project 2. May not give the value-maximizing decision 3. Considers the time value of money when used to compare mutually exclusive 4. Considers the risk of future cash flows projects (through the cost of capital in the 3. May not give the value-maximizing decision decision rule) when used to choose projects when there is capital rationing 4. Cannot be used in situations in which the sign of the cash flows of a project change more than once during the projects lifeModified Internal Rate of ReturnAdvantages Disadvantages 1. Requires an estimate of the cost of capital in 1. Tells whether an investment increases order to make a decision the firms value 2. May not give the value-maximizing decision 2. Considers all cash flows of the project when used to compare mutually exclusive 3. Considers the time value of money projects 4. Considers the riskiness of future cash 3. May not give the value-maximizing decision flows (through the cost of capital in when used to choose projects when there is the decision rule) capital rationing

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