Question

The controller of your company, Sarah Mendez, is in the process of writing a procedures manual for making capital budgeting decisions. Specifically, Sarah asks you to write procedures for how to calculate the following items/formulas: Payback period, Accounting rate of return, Net present value, and Internal rate of return In your procedures, please also include a listing of the advantages and disadvantages of each method. The idea is a one-page place to find everything you need to know about each method.

Required: Pick one (only) of the four items/formulas to write about. Include a minimum of three of the following five topics in your initial discussion post: Formula Advantages Disadvantages How effective is the tool you selected making capital budgeting decisions? Explain. What could possibly happen if the item you selected was calculated incorrectly?

Answer 1

Payback Period:
The payback period is the length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions.
Formula = Payback in the number of years = Initial Investment/Cash flow per year
Advantages:
• The most significant advantage of the payback method is its simplicity. It's an easy way to compare several projects and then to take the project that has the shortest payback time. However, the payback has several practical and theoretical drawbacks.
• Simplicity. The concept is extremely simple to understand and calculate. When engaged in a rough analysis of a proposed project, the payback period can probably be calculated without even using a calculator or electronic spreadsheet.
• Risk focus. The analysis is focused on how quickly money can be returned from an investment, which is essentially a measure of risk. Thus, the payback period can be used to compare the relative risk of projects with varying payback periods.
Disadvantages:
Neglects cash flows received after payback period:
For some projects, the largest cash flows may not occur until after the payback period has ended. These projects could have higher returns on investment and may be preferable to projects that have shorter payback times.
Ignores a project's profitability:
Just because a project has a short payback period does not mean that it is profitable. If the cash flows end at the payback period or are drastically reduced, a project might never return a profit and therefore, it would be an unwise investment.
Does not consider a project's return on investment:
Some companies require capital investments to exceed a certain hurdle of rate of return; otherwise the project is declined. The payback method does not consider a project's rate of return.
Payback Period for Capital Budgeting
The capital project could involve buying a new plant or building or buying a new or replacement piece of equipment. Most firms set a cut-off payback period, for example, three years depending on their business. In other words, in this example, if the payback comes in under three years, the firm would purchase the asset or invest in the project. If the payback took four years, it would not, because it exceeds the firm's target of a three-year payback period.