AFM273 Chapter Notes - Chapter 6: Payback Period, Net Present Value
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17 Feb 2015
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Chapter 6: the difference b/w the cost of capital and irr is max. amount of estimation error in the cost of capital estimate that can exist without altering the original decision. Npv rule: accept project when npv is positive. Internal rate of return (irr) investment rule: the rate of irr is when npv = 0, take investment where irr > cost of capital. Turn down investment where irr < cost of capital. Irr rule has shortcomings for making investment decisions. Irr measures the average return of the investment and the sensitivity of the npv to any estimation error in the cost of capital. Payback rule: payback period is the amount of time it takes to recover or pay back initial investment. If payback period is less than pre-specified length of time, accept the project. Mutually exclusive projects: when you must choose only one project among several possible projects, choice is mutually exclusive, npv rule select project with highest npv.
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