FINC 620 - Financial Management
May 19, 2014
According to Investopedia, capital budgeting is the process in which an organization decides whether certain large projects, such as building an addition or purchasing large equipment, are worth the investment (Capital budgeting, 2014). If capital budgeting in not performed prior to a major purchase or beginning a large project, it could be detrimental to an organization. Because of the limited amount of capital that may be available to an organization at any given time, it is critical that company leaders utilize capital budgeting methods to make the determination which ventures will bring the company the biggest return on their investment. Among these capital budget methods are Payback Period, Net Present Value (NPV), and Internal Rate of Return (IRR). Payback Period
According to Marty Schmidt, the payback period is the cash flow analysis metric that calculates the length of time for capital acquisitions or investments to pay for themselves, the length of time it takes to cover costs, or what is the investment breakeven point (Schmidt, 2014). The payback period is quite an easy financial metric, and is equal to the organization’s required investment, divided by its net annual cash inflow. An alternative payback period calculation, used by larger companies that seek more extensive information, is that payback period equals the number of years before the full investment recovery, plus the unrecovered cost at the beginning of the year, divided by the full recovery year’s cash flow.
Payback period is not a completely robust capital budgeting method and is not always the correct method to choose when calculating capital budget. For a more exact payback period, the second equation given above should be used. The disadvantages of the payback period method are that it doesn’t account for the time value of money and it ignores cash flows beyond the payback period. The disadvantage of ignoring cash flows beyond the payback period is the most critical, as it equates to ignoring the profitability of the capital expenditure or major project. Net Present Value (NPV)
According to the Business Dictionary, net present value is the difference between the amount of an investment and the present value of future cash flows from that investment (Net present value, 2014). The calculation for net present value is the project’s present net cash inflows value, minus the organization’s initial investment. It is important for an organization to calculate net present before it makes big financial decisions because NPV takes into account the value of today’s dollar in comparison to the value of the future dollar. Even though the net present value method is not the most advanced capital budgeting method, it is the most popular method used by financial decision-makers that want to estimate when their initial investment will be paid back.
As with the payback period method, net present value also has some disadvantages. One disadvantage is that the method’s accuracy lies within the inputted data by the organization’s financial personnel. Each cash flow size, the occurrence of each cash flow, and the exact discount rate must be known by the financial decision makers of the organization for the model to function effectively. Another disadvantage is that to be fully effective, the net present value can only be used to perform a comparison on same-time projects. Additionally, the net present value method does not sufficiently provide the overall gain/loss of implementing the capital project. This is due to the fact that the method is based on the estimated project’s future cash flows, which can be far from the real cash flows. Internal Rate of Return
According to the Business Dictionary, internal rate of return is average annual return that is earned through the investment’s...
References: Capital budgeting. (2014). Investopedia. Retrieved May 19, 2014, from http://www.investopedia.com/terms/c/capitalbudgeting.asp
Internal rate of return. (2014). Business Dictionary. Retrieved May 20. 2014, from http://www.businessdictionary.com/definition/internal-rate-of-return-IRR.html
Net present value. (2014). Business Dictionary. Retrieved May 19, 2014, from http://www.businessdictionary.com/definition/net-present-value-NPV.html
Schmidt, M. (2014). Payback period explained. Building the Business Case. Retrieved May 19, 2014, from http://www.business-case-analysis.com/payback-period.html
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