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Compare KEY DCF AND NON-DCF METHODS

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Explains in detail the DCF and non-DCF methods for analyzing investment decisions.

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What is an investment decision rule?
When faced with new investments and projects, firms have to decide whether to invest in them or not. The characteristics of a good investment decision rule are:
 First, a good investment decision rule has to maintain a fair balance between allowing a manager analyzing a project to bring in his or her subjective assessments into the decision, and ensuring that different projects are judged consistently. Thus, an investment decision rule that is too mechanical (by not allowing for subjective inputs) or too malleable (where managers can bend the rule to match their biases) is not a good rule.
 Second, a good investment decision rule will allow the firm to further our stated objective in corporate finance, which is to maximize the value of the firm.
 Third, a good investment decision rule should work across a variety of investments.

Keeping above three in mind we have to look at which methods - DCF based or non-DCF are better.

KEY DCF AND NON-DCF METHODS

NON-DCF METHODS
Payback Period: The payback period is simply the time taken by the project to return your initial investment.
Calculation:
The cash flows from each year are added to find out the point in time at which the cumulative cash flows equal the initial investment.

Decision rule and interpretation:
Accept projects with payback less than some specified period. E.g. Accept projects with payback of 4 years or less. Payback represents the number of years required for the original cash investment to be returned.

Book Rate of Return (BRR): This is a rate of return measure based on accounting earnings and is defined as the ratio of book income to book assets.

Decision rule and interpretation:
Accept projects with returns greater than the average return on the book value of the firm, or some external ...

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