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This reflects the riskiness of the investment and is measured by the volatility of cash flows and take into account the financing mix. Ideally, businesses should pursue projects and opportunities that enhance shareholder value. However, because the amount of capital available at any given time for new projects is limited, management needs to use capital budgeting techniques to determine which projects will yield the most return over an applicable period of time.
The author has discussed popular methods of capital budgeting which include net present value NPV , internal rate of return IRR , Real Option and payback period. The r e s u l t s o f analysis conducted in Europe, America and Africa have confirmed the widely acceptance of this method because of its simplicity, liquidity and the manager's incentives packages among others.
Body The real value of capital budgeting is to rank projects. Most organizations have many projects that could potentially be financially rewarding. Once it has been determined that a particular project has exceeded its hurdle, then it is ranked against peer projects.
The highest ranking projects are implemented until the budgeted capital has been expended. The author has discussed four capital budgeting tools in this article The value added by this thesis is twofold. Secondly, the thesis is not limited to just discussing financial criteria of investment project evaluation.
The thesis project has also considered the investment decision process in general. The author has focused on the capital budgeting decision making in corporate organizations. He applied four common capital budgeting decision tools to analyze past research data on companies in Africa, Europe and America.
The tools discussed include the payback period, net present value NPV method, the internal rate of return IRR method and Real Options to substantiate the importance of using payback method in making capital budget decisions in relation to other appraisal techniques.
Payback Period- The payback period is the most basic and simple decision tool. The usual decisions rule is to accept the project with the shortest payback period. Payback method does not measure overall project worth because it does not consider cash flows after the payback period. According to T. Lucy, payback period provides only a crude measure of the timing of project cash flows. The payback period is probably best served when dealing with small and simple investment projects.
The author observed that the simplicity of payback period method should not be interpreted as ineffective. If the business is generating healthy levels of cash flow that allow a project to recoup its investment in a few short years, the payback period can be a highly effective and efficient way to evaluate a project. When dealing with mutually exclusive projects, the project with the shorter payback period is selected. Net Present Value NPV - The net present value decision tool is a more common and more effective process of evaluating a project which the author has also analyzed.
The article revealed that the NPV tool is effective because it uses discounted cash flow analysis, where future cash flows are discounted at a discount rate to compensate for the uncertainty of those future cash flows. In the case of mutually exclusive projects, the project with the highest NPV is accepted. In a budget-constrained environment, efficiency measures should be used to maximize the overall NPV of the firm.
It evaluates investment projects in the way as investors do Shapiro, The NPV has several strengths and weaknesses. Though the method has a number of strength Brealey, , Shapiro, , Ansari, the concept may be hardly understood due to its complexity Shapiro, The model gives a false sense of accuracy, since the computed present value is based on estimated and uncertain cash flows Ansari, Internal Rate of Return IRR — From the literature, the author defined that the internal rate of return is discounted rate that is commonly used to determine how much of a return an investor can expect to realize from a particular project.
The author further stated that the internal rate of return is the discount rate that occurs when a project is break even, or when the NPV equals 0 and the decision rule is to choose the project where the IRR is higher than the cost of financing. The greater the difference between the financing cost and the IRR, the more attractive the project becomes.
The authors assertion confirms Brealey, , p93 statement which states that internal rate of return rule is to accept an investment project if the opportunity cost of capital is less than the internal rate of return.
These issues can arise when initial investments between two projects are not equal. The advantages of using the IRR are Ansari, Real options - Real options analysis values the choices - the option value - that the managers will have in the future and adds these values to the NPV. Real option analysis has become important since the s as option pricing.
The model is more sophisticated as mentioned by the author in his article. It provides flexibility to management — i. Using this model, managers have many choices of how to increase future cash inflows, or to decrease future cash outflows. The analysis has shown that managers can use models such as the CAP or the APT to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital WACC to reflect the financing mix selected.
A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. However, a higher discount rate is more appropriate when a project's risk is higher than the risk of the firm as a whole. Hypotheses The hypothesis have been confirmed for the most general methods and criteria. These methods and criteria are that companies prefer the use of the pay back method when they evaluate investment opportunities because of its simplicity and that the companies have to do with financial flexibility.
The method chosen are related to the pecking order theory and budget. This confirms that companies apply both financial evaluation criteria and non-financial. In addition, the article reveals that both risk and uncertainty are considered when evaluating investment projects and that well-defined investment decision processes are employed when appraising projects.
Data Source and Method of Collection The author used theories on payback period method and past research work which companies used in appraising investment and he has used it as secondary data in order to be able to answer the questions raised in the research hypothesis. The author used empirical studies and personal judgment to analyze data from the selected countries on how often the countries use the payback and other methods to reach a conclusion on why the country or the continent used the method in question.
Furthermore the analyzed data has shown how each continent has favored the use of the payback method. To agree with the above statement, the author analyzed secondary data from the result of the survey conducted among firms in Africa, Europe and America.
Due to the number of expected results from the hypothesis, the author used a combination of quantitative and qualitative methods to provide the best possible result from the analysis. This process and its application reflect the level of quality both companies want to be perceived with not only internally, but also by external stakeholders such as customers, suppliers and investors though the result of the research benefited mostly financial managers.
The author has managed to establish why payback method is often used indifferent continents and he managed to trace the reason why some particular continents prefer payback method, which is primarily based on the kind of industry that run the economy of such countries, a common example is the manufacturing industry. The author noted that companies in advanced countries often use the payback method because of the capital structure while companies in Africa mostly tend to use the payback method mainly because of the availability of the internal funding Further analysis of the research shows that the prevalent use of the payback period is more pronounced in the Europe, followed by North America and then Africa.
The results show that European companies most often use the payback method followed by American companies and lastly the African companies. There as on the African companies were rated last is due to the fact that one of the African countries i. Nigeria showed a high rate in the use of the payback method while the other African country i. South Africa showed a very low rate in the use of the payback method.
The article has revealed that from the past reports how is that manufacturing companies in Europe and American companies often used the payback period, compared to other sector of the economy. The author concluded that the issue of the relevance of the use of the payback method is motivated by the importance of the payback method which includes the size of the business, the goal function, the management attitude to the pecking order theory and the simplicity of using the method.
Also from the data obtained, the simplicity of the payback period has motivated the use of the method. Managers normally will want to use a very simple formula to make their investment decision. Although developed countries are now more interested in using some complicated formulas like real option, NPV, IRR but the conclusion is that the simplicity of the payback method made it to be easily understood and this has motivated the general use of the payback method.
Payback is perhaps the simplest method of investment appraisal. The payback period is the time it takes for a project to repay its initial investment. Payback is used measured in terms of years and months, though any period could be used depending on the life of the project e.
Payback focuses on cash flows and looks at the cumulative cash flow of the investment up to the point at which the original investment has been recouped from the investment cash flows. Looking at the example investment project in the diagram above, the key columns to examine are the annual "cash flow" and "cumulative cash flow" columns. Thereafter the project generates positive annual cash flows.
However, during Year 4 the cumulative cash flow reaches the payback point at which the original investment has been recouped. To calculate the precise payback period, a simple calculation is required to work out how long it took during Year 4 for the payback point to occur. The trick is to make an assumption that the cash flows arise evenly during each period.
That allows the following calculation:. The main advantages and disadvantages of using Payback as a method of investment appraisal are as follows:. Emphasises speed of return; may be appropriate for businesses subject to significant market change. Ignores cash flows which arise after the payback has been reached — i. Jim co-founded tutor2u alongside his twin brother Geoff! Jim is a well-known Business writer and presenter as well as being one of the UK's leading educational technology entrepreneurs.
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This is determined by simply dividing the amount used to start the project and the amount that the project is generating per year. A project with shorter payback period implies higher returns. Numerous companies have maximum acceptable payback period however when they decide on which investment to go with, they will consider projects with less payback period than them. So, what are the advantages and disadvantages of payback period? It Is Simple A significant percentage of companies use employees with different backgrounds to analyze capital projects which is not only biased but a difficult process to understand.
On the other hand, payback method looks at the number of years which make it simple and easy to understand. Offers Quick Evaluation Determining which projects can generate fast returns is important to companies especially those with limited resources.
Managers of such companies use this method to make a quick evaluation regarding projects with the small investment and short payback period. Ignores Time Value of Money The method ignores the time value of money. Investments are usually long term and continue to generate income even long after they have paid back their initial start-up capital.
However, if a project has a long payback period it gets overlooked. The PP coefficient payback period shows the time period, for which the initial investment in the project will be repaid when the invested money will be returned. This formula allows you find the payback period indicator of the project quickly. But it is extremely difficult to use it, because monthly cash receipts in real life are rarely equal amounts. Moreover, the inflation is not taken into account.
Therefore, the indicator is used in conjunction with other criteria for assessing effectiveness. ARR, ROI — there are coefficients of profitability, showing the profitability of the project without discounting. The higher the profitability ratio, the more attractive the project. The main disadvantage of this formula - is that it is so difficult to predict future receipts. Therefore, the indicator is often used for analyzing of the existing enterprise. Statistical methods do not take into account discounting.