Question

A company, EFG Inc., is considering to replace one of the components of its old machines with a new one, in order to enhance the efficiency of the production process. As a Finance major currently undergoing practical training at the company, the manager would like you to run some analysis and provide your recommendation as to whether to accept or reject the proposal. You plan to use some of the common techniques to evaluate such a project, i.e. payback period (PP), discounted payback period (DPP) and NPV. To do so, you need to collect the relevant information which will allow you to appropriately evaluate the project.  

In your own words, describe the type of inputs or information which you need in order to compute and help you reach a decision on the three measures. Then, compare and contrast between the PP, DPP and NPV, by specifically referring to the project above. In other words, discuss the difference(s), similarity(ies), and relationship(s) in terms of the expected outcomes between/among the techniques. State your assumptions (if any), and provide examples as necessary.

Answer 1

Payback period is a capital budgeting tool which is used in order to select various projects by determining the period in which the actual outflows of the companies is recovered through cash flows. In this method earlier the recovery period, the better it is for the company to accept a project.

Discounted payback period method is a method similar to the payback method but it adds the effect of inflation and time value to the cash inflows.the cash inflows are discounted and then they are equalised with the cash outflows at the beginning in order to arrive at a discounted payback period.

Net present value is a method in which the cash flows are discounted at the present value and then they are matched with the cash outflows so it is then find out that whether the net present value is positive or negative when the net present value is positive,it will mean that the project will be resulting in benefits for the company and it is to be accepted.

all these three methods of different nature and their applicable in different scenarios as payback period method is highly outdated method as it does not consider the time value of money where as the other two methods are adaptable in nature because they are factoring in for the time value of the money and net present value method is the best used method as it is considering even after the project have become positive.

So, all three method are thoroughly analysed and then the best method is to be selected which is suitable to the company.