# Capital Budgeting

**Topics:**Net present value, Internal rate of return, Rate of return

**Pages:**3 (698 words)

**Published:**November 1, 2006

The simplest capital budgeting method is the payback method. The analyst must calculate the number of years it will take to recoup the project's initial investment (Gallagher, 2003). This is done by adding up the project's cash inflows one year at a time until the sum equals the amount of the project's initial investment. The number of years is the payback period. To evaluate this method, the manager must have in mind a particular number of years that is acceptable to the firm. If the payback period is less than or equal to that predetermined number, then the project is accepted.

Payback Method for Strident Marks Project

Period

0Initial Investment-$10,000

1Cash Flow$7,500

Remaining-$2,500

2Cash Flow$7,500

Remaining$5,000

3Cash Flow$7,500

Remaining$12,500

Solution:

Payback (in years) =1 + (5,000/7,500)

Payback =1.67years

The decision rule for payback method depends on management's acceptable payback period. If the proposed project's payback exceeds the acceptable time limit, then the project is accepted. Otherwise, the project is rejected.

The problem with the payback method is that this method does not consider cash flows that occur after the payback period, nor does it consider time value of money (Gallagher, 2003).

The second method that Strident Mark's can utilize to analyze the worth of its impending project is to use the net present value (NPV). NPV of...

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