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Business Finance - Essay Example

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Business Finance

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 ...Show more

Summary

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…
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Business Finance Essay essay example
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