Capital Budgeting. Payback Period. NPV - Essay Example

Another reason why these decisions are so important is that these decisions involve a large outlay of funds. Therefore, it is necessary that these decisions are taken with due diligence. These decisions cannot be reversed at a low cost. So, any mistake made is very costly to the firm. The capital budgeting process that a manager uses depends on a few factors such as the manager’s level in the organisation and the size of the project and the organization. The following steps are the typical steps followed by most managers.

Step One: Generating Ideas Coming up with good investment ideas is the most important step in the capital budgeting process. Good ideas can come from anywhere in the organisation. It can come from managers from any level or from any department in the organisation or even from outside the organisation. Step Two: Analysing Individual Proposals This process involves collecting all the information to forecast the cash flows for each project and evaluating the profitability of each project. Step Three: Planning the Capital Budget Now the company has to organise the projects that are profitable so that they fit within the company’s overall strategy.

Step Four: Monitoring and Post-auditing In post-auditing, the actual results are compared with the predicted results and the differences are explained. Post-auditing helps monitor the forecast, improve business operations and generate ideas for future investments. 2. Memo to Assertive Al One of the main drawbacks of using the payback method is that it does not take time value of money into account. For example a cash inflow of $2 million in the third year of the project is going to be less today.

It also ignores all the cash flows beyond the end of the payback period. This can present a critical problem for the firm as some projects give higher cash inflows in later years (after the cut-off date). Discounted payback method can to some extent overcome the drawbacks of the payback method as it considers time value of money into account. In a discounted payback period, the future expected cash flows are discounted by the project’s cost of capital. By discounting expected cash flows through the cost of capital, the discounted payback method considers the riskiness of the project into account.

Similar to the drawback of payback method, the discounted payback method also does not consider cash flows after the discounted payback period. As there are flaws in the payback methods, these methods cannot be considered as most reliable in evaluating future projects. Hence in order to be more effective in evaluating projects, Net Present Value method is considered to be the most reliable and effective method in evaluating future projects. Unlike the payback methods, the Net Present Value method does take distant future cash flows into account (after the cut-off payback period).

NPV rule is important as it takes time value of money into account as a dollar today is worth more than a dollar tomorrow, the reason being that the dollar today can be invested immediately to start earning interest. NPV also eliminates the time element in evaluating projects, as some projects start earning positive cash flows after a long period and the payback methods are not viable in evaluating such projects. 3. NPV Managers want to know more about a project than just its NPV because the NPV method also has certain drawbacks.

The major drawback of the NPV method is that