The type of capital budgeting preferred for Tech Buzzard is the Net Present Value method. The initial outlay of cash to get my firm started is low which makes the risk low. Tech Buzzard will start as a part time venture out of my home with very little of my own capital investment to lose. Never-the-less, I will use NPV as the primary analytical tool but I will also look that the IRR and Profitability Index for a more informed view of the payback period.
PAYBACK PERIOD RULE IS LIKE A MEAT CLEAVER
I would not want a C-Section with a meat cleaver, nor would I want to run my business using just the payback method. The payback period rule alone is a clumsy way to evaluate risk in that it just looks at a length of time for repayment of the incoming cash flows to equal the original capital investment amount. Payback does not take risk, TVM, or incoming cash flow after the cutoff point into consideration which could be extremely high or low and negate any data gleaned prior to that time. With this method, it is too difficult to discern the correct cutoff period. What if there is a huge negative cash flow in year three and the cut off period is after year two? This method is calculated the same way for projects that are safe or risky.
NPV IS LIKE A SURGEON’S SCALPEL
Scalpels are nice and sharp and get the job done with minimal injury to tissues similar to the NPV rule which is the main method of analysis when deciding whether a project should be accepted or rejected. If you could only choose one tool, this is the one that I select to find out the most accurate assessment of my company’s investment value. The NPV looks at the difference between the current market value and its original cost. The decision then becomes cut-and-dry. If the NPV is positive, my project is a fairly safe bet and should be a ‘go.’ If it is negative, it should be passed up.
Ross-Westerfield-Jordan: Essentials of...