Capital Expenditure Valuation Methods
The payback period is the time it takes for a project or investments cash outflows to be recovered by cash inflows generated from the same project or investment. It is a very simple and commonly used capital budgeting technique. The formula used to compute the payback period is initial investment divided by cash inflow per period. You generally want to choose the investment that provides the shortest payback period, because you will get you cash back and it can be put toward other investments or projects. The longer the payback period the riskier it is. Top management will normally have a target payback period. They should select the project that offers a payback period less than the target. There are a few advantages of using the payback period calculation. It is very simple to calculate, and it is a good measure of risk in a project. As stated before, the longer it will take to return the money on the project the riskier it is. Also, for companies that have liquidity problems, it provides a good resource on what investments will return money the quickest. A big disadvantage of the payback period is that it does not take into account the time value of money which can lead to wrong decisions. It also ignores any benefits that occur after the payback period, so it does not accurately measure profitability.
The discounted payback period is also used to compute the time it takes to recover the cost of an investment, but it works to correct the disadvantage of the payback period by accounting for the time value of money. To calculate the discounted payback period, a discounted cash flow is used in the calculation. The discounted cash inflow is calculated by dividing actual cash inflow by the present value of each cash inflow. To do this management has to establish an appropriate discount rate. The advantages of using the discounted payback period is that it accounts for the time value of money, and it provides management...
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