easy · Principles of Finance capital-budgeting
A manager says: 'Project X is better because it pays for itself in 2 years, while Project Y takes 4 years.'
Why is this reasoning dangerous in capital budgeting?
- It requires the firm's WACC to sit at or above roughly 50% for the comparison to hold true.
- Shorter payback periods always translate directly into a lower internal rate of return.
- It assumes that the project's internal rate of return is exactly zero for the first two years.
- It ignores the time value of money and all cash flows occurring after the second year.
Sign up free to see the explanation and track your rank →
More Principles of Finance capital-budgeting practice
- According to the Net Present Value criterion, which project should be chosen?
- Calculate the 'Profitability Index' for a project with an initial cost of 200,000 and a pr
- If the required rate of return is 10%, what is the Net Present Value (NPV)?
- Which type of 'real option' is being exercised when a pharmaceutical company decides to bu
- What is the project's Profitability Index (PI) at a 10% discount rate?
- If the cost of capital is 10%, what is the Net Present Value (NPV) of the project?
- A firm has FCFF of $100M, interest expense of $20M, a tax rate of 25%, and net new borrowi
- What is the Profitability Index (PI) and what does it indicate for capital rationing?