Payback period (pp): The PP method measures the time required for the return on investment to be made from the actual cash flow generated by a project. Thus, projects that will recover the initial investment faster are considered more attractive, and therefore the emphasis on liquidity is given priority over profitability in the PP approach. The time factor plays an important role here, for which reason, PP is considered a better option than the ARR method. However, PP features its own drawbacks, as it emphasizes on the payback period only and is not viewed with the actual profitability of a project. This may result in valuable profitability information being omitted, which indicates that PP will not promote the increase in wealth to the shareholders, but will favor projects that have the shortest payback period. The simplicity of this method has made it very popular among managers of smaller businesses that lack the required knowledge on the use of discounted cash flow methods (NPV and IRR) (Atrill & McLaney, 2011 p.403), which we will discuss hereinafter.
Net present value (NPV): The NPV method is considered to be a better solution of investment appraisal, as it covers the cost and benefits of a project as well as the timing factor in the computation. The NPV discounts the future expected cash inflow from an investment project reflecting the interest lost to the investors, the related risk and the expected inflation. According to Kierulff (2008) If the sum of the discounted future cash inflows exceeds the initial cash requirement for funding, NPV is positive, and the project is financially attractive (Kierulff, 2008 p.321), thus adding value to the investors. In fact, NPV considers the timing of cash flows,' the whole of the relevant cash flows and the objectives of the businesses in its computation, which is why NPV is considered to be the preferred choice for decision makers. Further, the NPV uses all the differences between every possible IRR for a project and its cost of capital; therefore NPV is a richer concept (Osborne, 2010 p238)
4.0 How do you think that capital budgeting decisions should ideally be made by different types of organizations?
In any type of organization, investment appraisal and capital budgeting should be based on calculations, that provide a clearer picture of what is to be expected in terms of returns on investments made. Here we would suggest the implementation of a step-by-step phased approach to any project envisaged. The phased approach should consist of five steps, as follows: 1. Defining a real opportunity (identifying a potential project/investment, that is expected to generate a good return on investment) 2. Outlining a conceptual study (describing how the opportunity may be achieved) 3. Pre-feasibility Study (studying various options or projects and selecting the most favorable/profitable one) 4. Feasibility Study (studying the most suitable project, and confirming its suitability5. Investment Decision (deploying the necessary funds to finance the new investment)
Following a phased approach, it would help in improving the cost-effective deployment of the funds and will result in more disciplined decisions. Most importantly, if a particular investment would not show signs of viability, the project can be stopped at a minimum loss to the investors. It is important for the investors to focus on the essence of making well informed decisions when it comes to making investments.
Atrill, P. & McLaney, E. (2011) Finance and accounting for managers, Laureate Online Education customed., Harlow UK, Pearson Custom Publishing.
Dun & Bradsteet (2008) SME Lending in the UAE: 2008, D&B Business Insight Series, Industry Perspective
Available from: http://dnbsame.com/downloads/D&B_SME.pdf(Accessed 7 October 2011)
Osborne, M.J. (2010) A resolution to the NPV-IRR debate? The Quarterly Review of Finance and Economics, 50 (2), pp.234-239, ScienceDirect. Available from: : http://sfxhosted.exlibrisgroup.com.ezproxy.liv.ac.uk/lpu?title=Business+Horizons&volume=51&issue&spage=321&date=2008
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