Advantages and Disadvantages of Payback - Assignment Example

Advantages and Disadvantages of Payback Payback period Payback period refers to the time period required to recover the initial cost of investment. The payback period helps organizations to determine whether a given an invest proposal or a project is worth undertaking or not. The payback period is calculated as follows: Payback period= Initial investment / annual cash inflows. The above formula is applicable when the annual cash inflow of each financial year remains same. On the other hand if the cash inflows are seen to vary every year, then the cumulative cash inflows are taken into consideration. Payback period is an effective accounting tool for organizational managers to take strategic decisions about investing in a given investment proposal. Payback period is also an effective capital budgeting technique whereby the break-even point for an investment proposal is calculated. When investment is made in a project, there are no profits earned in the initial few years of operation. Profits are earned after the business achieves break even, where the level of investment made in the project becomes equal to the inflow of cash earned over the years. If the initial investment made in a project $150,000 and the cash flows each year is $50,000. Then the payback period as per the above formula is 3 years. At the end of the third year the company will be able to recover the entire investment that it has made in the project. From the third year onwards the company would be earning profits upon the project. In case of two or more mutually exclusive projects, the management is seen to select the one which has a lower payback period (Baker and English, 2011). Advantages and disadvantages Payback period is one of the simplest capital budgeting techniques to appraise a given project. It is easy to use and simple to calculate. Payback period helps managers to understand the time period required to attain liquidity in a given investment proposal. It also helps the management to analyze the risk factor in a given investment proposal. The longer the duration of the project, the higher is the risk factor. Payback period does not take into consideration the time value of money. This is because the method does not take into consideration discounting of future cash inflows to arrive at the present value of net inflow. Payback period helps in understanding the liquidity factor associated with projects ignoring the profitability factor completely. The system takes into consideration only the inflow of cash prior to the payback period and does not consider the cash inflows after it (Bierman and Smidt, 2007). Net present value The net present value (NPV) is the difference between the net present value of future cash inflows and the initial investments made in the project. The present value of future cash inflows is calculated by discounting the future cash inflows using the rate of return factor. The present value of future cash inflows in generally lower than its future value. The difference occurs due to the time value of money which gives consideration to the interest factor in the value of money. While calculating the net present value, the discounted cash inflows of the project over a given number of years is ascertained. The net discounted value is then deducted from the initial amount invested in the project to ascertain the NPV. If the NPV is negative, it signifies that the net returns available from the project is lower than the investment made and hence should be undertaken by the company. On the other hand if the NPV is positive, the project can be considered as profitable. Higher NPV is considered to be more beneficial for the organization. In case of mutually exclusive projects, the one with the higher NPV has the greater chances of acceptability. The NPV method of capital budgeting is based upon certain assumptions. It is assumed that the revenue generated from a project, is immediately reinvested in the same. The investment is made at a rate of return which is equal to the present value factor. The inflow and outflow of revenue except the initial investment is assumed to occur at the end of each period (Dayananda, et al., 2002). Advantages and disadvantages The NPV method gives importance to the time value of money. While calculating NPV, the net cash flows over the life span of the asset or the project are taken into consideration. Profitability aspect in the project is given high preference. Since the returns available from the project over its lifespan are taken into consideration, adequate importance is also given to the risk factor associated with the project. If the NPV is low or negative then the risk factor is high. NPV is generally considered as a suitable project or investment appraisal technique by most stakeholders of the business, as it helps in maximizing a firm’s value. NPV method involves elaborate calculations and is therefore considered as a complicated and time consuming process. When the initial investment amount for mutually exclusive projects s seen to vary, then NPV cannot be used as an effective tool for decision making. Similarly, the method may not provide accurate results if the assets or projects are of unequal life span. Organizations many a times find it complicated and difficult to calculate the exact discounting factor while using this method of capital budgeting (Joehnk, 2012). Weighted average cost of capital (WACC) Organizations are required to use a discounting rate for ascertaining the present value of future cash flows while appraising different investment proposals. The discount rate is the cost of capital. The capital structure of an organization consists of different types of capital such as equity and debt. Investment is made in different proposals using the capital provided by different types of long term finance providers. The weighted average cost of capital refers to the cost incurred to acquire finance from different sources. It is the minimum returns which an investment is supposed to yield so that the cost of capital can be covered (Shapiro, 2008). The returns generated from different projects are used for satisfying the needs of shareholders, long term debt providers and creditors who are the primary finance providers of the business. If the minimum rate of return is not earned through the investment, there is a high chance that stakeholders will withdraw their investments. This hampers the project and the business immensely. It is therefore essential for the management to invest in such a project which is capable of generating adequate amount of returns. In order to ensure that projects. Weighted average cost of capital is used as a discounting factor while appraising different projects in the capital budgeting technique. Investments in different proposals are made utilizing the finance available from stakeholders of the business. It is essential that the stakeholders are provided with adequate and timely returns for the investments made by the. This requires the project to yield sufficient rates of return. In order to ensure that the rate of returns derived from projects is adequate to meet the needs of business stakeholders, the weighted average cost of capital is used as a discounting factor. This helps in appraising the projects in a manner such that sufficient and adequate yields can be earned upon the net investments made. The WACC is calculated taking into account the risk aspect existing in the market. This includes the risk free rate of return and market risk premium. Since the WACC takes into consideration both the minimum rate of return required and the risk, it is considered as a suitable tool for appraising investment proposals (Chandra, 2005). The weighted average cost of capital represent the average risk that firms face. Investment proposals might carry a higher risk than the average level of risk. Under such circumstances a firm is seen to raise the rate of WACC so that it can be suitably used as a discounting factor. Similarly in circumstances when the risk associated with projects is lower than the average risk, then the WACC is lowered by a considerable margin. Long term finance for a large PLC Long term sources of finance for a large Plc are generally required for a period exceeding a year. Long term financing generally involves bulk amount of investments. Long term finance is used for meeting business requirements such as expansion of operations, development of new products and services, acquisition of assets. Firms usually do not rely upon just one source of capital to meet such requirement. Long term needs of finance are met with the combination of different types of sources of finance. The type of long term sources of finance chosen by a company will depend on numerous factors such as cost of capital, legal status and financial outlook (Frank and Goyal, 2009). The long term sources of finance which are available for a Plc are discussed as follows. Share capital Equity share capital is also known as owner’s capital. Shareholders of a firm obtain the rights to vote during the annual general meeting. They are also provided with a share in the profits of the company in the form of dividends. Shareholders in general are recognized as owners of the entity and are involved in taking important strategic decisions which effect the functioning of the organization. Shareholders are required to bear immense risks. The dividends that they receive depend upon the amount revenue earned by the organization. If the Plc earns very less revenue, then the amount payable as dividends would also consequently be low. Therefore shareholders are seen to ensure that they invest in firms which have the capability of earning high revenues. This raises the earnings available to shareholders considerably. Dividends to shareholders are paid out the residual earnings of the organization after meeting all other expenses. Share capital can further be divided into ordinary share capital and preference share capital. Preference share holders are given greater priority over ordinary shareholders in terms of payment of dividends. They receive a fixed amount of dividend annually. However preference share holders are not given voting rights in the annual general meetings of the company (Rioja and Valev, 2004). The primary advantage of acquiring equity share capital is that it involves very less amount of risk. When a firm is not able to generate sufficient amount of revenue, shareholders of the organization cannot force it to go into liquidation. Organizations are also not required to return the amount invested by shareholders as it is a form of permanent capital. However, one of the major disadvantages of acquiring equity share capital is that it dilutes the ownership rights of the Plc. Also the cost of acquiring equity share capital is high (Rioja and Valev, 2004). Debentures Debentures are a form of loan for which no collateral security is required. The principle amount of the debenture capital is required to be paid back after a fixed interval of time. The Plc is however is required to pay fixed interest upon the debenture amount irrespective of the amount of profits earned by the organization. The cost of acquiring debenture capital is low. However debenture holders are required to be paid off first before making payments to the shareholders on the event of liquidation (Bragg, 2011). Bank loan Bank loan is one of the most important types of long term finance which is acquired by a Plc. Such types of loan are generally acquired for a period exceeding five years and up to 25 years. There is a fixed rate of interest payable upon the amount of loan. Certain banks may require a collateral guarantee associated with the loans. Usually organizations prefer to keep the proportion of bank loan in their capital structure low as it involves the payment of high rates of fixed interest. Also, the rates of interest may vary from bank to bank. Bank loans are also considered to be a highly risky source of capital. If a Plc becomes insolvent, there are chances that the bank takes over its administration. Another major disadvantage associated with bank loans is that the interest applicable upon it fluctuates from time to time. The cost of acquiring such capital therefore increases. One of the major advantages associated with bank loan is that it can be acquired quickly and is suitable for investing in projects yielding high revenue (Carlin and Mayer, 2003). Reference List Baker, K. H. and English, P., 2011. Capital Budgeting Valuation. New Jersey: John Wiley & Sons. Bierman, H. and Smidt, S., 2007. The Capital Budgeting Decision. New York: Routledge. Bragg, M. S., 2011. Obtaining debt financing. New Jersey: John Wiley & Sons. Carlin, W. and Mayer, C., 2003. Finance, investment, and growth. Journal of financial Economics, 69(1), pp. 191-226. Chandra, P., 2005. Fundamentals of Financial Management. New Delhi: Tata McGraw-Hill. Dayananda, D., Irons, R., Harrison, S., Herbohn, J. and Rowland, P., 2002. Capital Budgeting. Cambridge: Cambridge University Press. Frank, M. Z. and Goyal, V. K.,2009. Capital structure decisions: which factors are reliably important? Financial Management, 38(1), pp. 1-37. Joehnk, G., 2012. Fundamentals of Investing. New Jersey: Pearson Education. Rioja, F. and Valev, N., 2004. Finance and the sources of growth at various stages of economic development. Economic Inquiry, 42(1), pp. 127-140. Shapiro, C. A., 2008. Capital Budgeting and Investment Analysis. New Delhi: Pearson Education India. Read More