The Capital Budgeting Method - Term Paper Example

Business Finance The payback period is commonly used investment criterion but almost all economists argue that the NPV is better. The payback method is one of the most popular tools in conducting capital budgeting decision. The payback period tells the company the length of time required to recoup the original investment through investment cash flows. This is essentially the time when the company breaks even-the initial capital outlay is equal to the cash flows. The payback period is computed as the follows: Payback = Initial Investment Annual Cash Flow (equation 1) Other things being equal, the investment with a low payback period is chosen as it implies less risk for the company. As the investment is recouped in a shorter period of time, it also indicates that the investment is less likely to fail. There are essentially three reasons why the payback method is popular among business circles. First of all, the payback method is simple. The computation is less complicated and is easily grasped by managers. The payback method is "easy to compute and easy to understand." Secondly, the payback method is gives some indication of risk. As this technique indicates the length of time that the investment can be recouped, it gives the company an opportunity to separate long-term projects to short-term ones. This also makes the payback method a good screening tool for prospective projects and alternatives. Lastly, this tool helps the company gain a more accurate and reliable assessment of a project by taking into account taxes and depreciation (Lightfoot 2003). It should be noted that the in the computation of cash inflow from operation, the aforementioned expenses are not overlooked. However, the use of the pay back period in assessing the profitability of an investment also suffers limitation. There have been a lot of criticisms on the efficiency of this method as a capital-budgeting tool. The payback method is not a reliable method of profitability because it stresses the return of investment and not on the return on investment. Instead of taking into account how much profit an investment can generate for a business entity, the payback method only tells the length of the time the investment is "returned." (Lightfoot 2003). Secondly, the payback method also falls short in measuring profitability as it ignores the cash flow after the payback period. It should be noted that after the company breaks even, there are still profits which are generated from the investment. Failure in including these cash flows will lead to understatement of profits. Lastly, the payback method ignores a very important principle-the time value of money. It is very important to include the time value of money in assessing the profitability of investments as the value of money today is relatively higher than its value say, a year or two years from now. Thus, managers who want to really know if the proposed project is really good for the company should discount cash flows. With this, economists favor the use of another capital budgeting method known as NPV. The net present value (NPV) of a project represents the present value of the total cash inflows and outflows. The NPV can be calculated by discounting the cash flows according to the required rate of return. the NPV can be mathematically represented as: (equation 2) where Ct is the cash flow in time t, Co is the cash flow during the first year, and r is the required rate of return. It should be noted that in the assessment of the profitability of an investment, it is also important to consider the timing of cash inflows. The rationale behind this is expressed in the concept of the time value of money which is widely recognized as one of the single most important concept in financial analysis. This tells us that a dollar to be paid today has a higher value than any dollar to be paid tomorrow. Holding a dollar has an opportunity cost in terms of interest. Thus, a dollar invested today can be turned into $1.10 next year when lent at 10% interest. In the same way, a dollar collected today will be used by a company to be invested in its profitable undertakings which can yield more dollars in the future. Thus, it can be deduced that investments which generates more cash earlier in their lives are more profitable. This might sound consistent with the payback period. However, it should be noted that NPV takes into account the total cash flow generated by the investment and does not stop when the total investment is recouped. NPV, unlike the payback period recognizes the importance of a company's preset return on investment. It should be noted that when the company calculates the return on investment using NPV, it measures the cash flow based on cost of capital. The payback period, on the other hand, only looks at the earliest possible time the investment is recouped and not at the investments meeting the standard of the company. 2. Extending credit to your customers is costly but might increase profits. A typical business organization extends credit to customer for various reasons. It is often uncommon to find a company which collects the totality of payment for its products and services in cash. It should be noted that extending credit exposes a business entity to risks of default. Unlike cash which ensures the full and ready payment of company's goods and services, credit only gives the customer an obligation. With credit, customers have the right to default for any reason. This leaves companies with receivables which be accounted for as bad debts and can be readily written off. To make things worse, companies will not be able to recoup their direct expenses in producing the product. This can mean huge losses for the organization. However, extension of credit is still common. This is due to the fact that credit has been a very important tool for business organizations which helps them achieve their goal of maximizing shareholder equity. In the side of the customer, credit functions like money because it gives them purchasing power to buy the goods and services that they cannot afford yet. In the part of the manufacturer or distributor, extending credit enhances the salability of goods. Aside from all these advantages of credit extension, it should also be noted that though the extension of credit poses some risk, it also enhances the profitability of a business organization. This point will be proven by looking at the effect of credit in the income statement, balance sheet, and cash conversion cycle. Credit and Income Statement It was stated above that credit enhances the salability of a good or service. In the company's income statement, this will be reflected in the form of higher revenue. A company is often measured by its ability to sell its products and services. The market share of a business organization which is the proportion of its sales to the total sales of the industry often indicates its market power and profitability. It should be noted that one of the measures or profitability is the level of revenue that a company generates. Since most companies use the accrual basis accounting, it doesn't matter if sales are in cash or in credit. Cash and credit sales are both recorded as revenues generated by the companies' operations and are often reflective of their ability to attract customers. Also, even if the credit sales are not collected and are written off, the sales account is not deducted by the amount of the bad debts. Thus, credit sales are instrumental in boosting the sales trend of any company. Credit Sales and Balance Sheet In the balance sheet, credit sales are recorded in the books' accounts receivables which, is a part of the company's current assets. Increase in credit sales consequently lead to an increase in resources. As with revenue, the company's profitability is often related to the level of its total assets. The size of a business organization is implied with the amount of resources, both current and fixed. Credit sales, as stated above, increase current assets. Thus, credit sales enhance the image of a company by boosting its resource size. Since accounts receivables are current assets, they also improve the liquidity of a firm. Credit Sales and Cash Conversion Cycle The cash conversion cycle is another indicator of a company's financial health. This tool is composed of three elements and is computed as follows: Cash Conversion Cycle = Average Inventory Collection Period + Average Receivables Processing Period - Average Payables Period, where average receivables processing period is computed as the quotient of accounts receivable and average daily credit sales (Cash Conversion Cycle 2006) . We can see that increases in credit sales or accounts receivables will lower this ratio, thereby leading to a total cash conversion cycle and implying higher profitability. In conclusion, companies should make use of credit to their benefit. Even though this tool exposes firms to risks, it had been proven that it can also enhance the profitability of a business organization. However, companies should improve their credit collection efforts in order for this projected profitability to materialize. Reference Cash Conversion Cycle, Retrieved 14 August 2006, from http://en.wikipedia.org/wiki/Cash_conversion_cycle Lightfoot, D. 2003, Return on Investment in CTP, Retrieved 14 August 2006, from http://www.newsandtech.com/ctp_chicago/presentations/ROI.pdf Read More