Valuation Methods: IRR and Payback Period

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For this project, the best method to use is the net present value. There are inherently flaws in both IRR and payback period that invalidate them as serious choices for determining a project's value. Payback period ignores all cash flows beyond the payback period, so does not effectively measure the contribution that the project makes to the value of the firm. IRR is better, but does not distinguish between the size of the projects. This weakness is most evident when comparing two mutually exclusive projects of different sizes. The IRR does not distinguish which project adds the most value to the company, only the one with the better return. The NPV distinguishes which option adds the most value to the company. Remember that management's role is to maximize shareholder wealth, and NPV is the measure that tells you which project does that. For this project, IRR is fine because there are no other options, but it is best to be in the habit of using NPV. The other thing worth noting here is with respect to MACRS. Equipment is in the 00.11 class, subject to a 7 year depreciation. In this example, the useful life of the equipment is five years, but the depreciation of the equipment would still be done over 7 years. The depreciation chart is as follows: Year 0 1 2 3 4 5 6 7 8 Depreciation 0.1429 0.2449 0.1749 0.1249 0.0893 0.0892 0.0893 0.0446 Dep Expense 35725 61225 43725 31225 22325 22300 22325 11150 The instructions already provide depreciation values, however, so it is

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