Capital Budgeting

The payback period looks at a project only until the costs have been recovered. This analysis tool is often ignored because it does not take into consideration the time value of money. The time value of money limitation of the payback period can be modified by using the discounted cash flows of a project for the analysis of when the outflows will be recovered.

EEC calculated the amount of time involved the anticipation of its cost ($3 million). The timeline in recovering their cost of investment ($2 million) initially for the foundation of this investment any profit made in the future of this investment will be justified as a profit for the company. If EEC can anticipate a fast return on its investment it is a profitable wise decision in making the investment financial, it is considered to be an easier way of formulating investments financially. On the basis of one year all cash flows is added together equal to the sum of $2 million originally invested, then it is divided by the annual cash flow of $500,000. The calculation of the payback period would equal four years. After this time frame any financial proceeds will be considered profitable for the company. I conclude that the timeframe is adequate in comparison of the investment in this worthwhile investment financial venture for the company.

In real live project with more cash flow after the pay back period would be more valuable than Project with no cash flow, yet its payback and discounted payback make it look worse. This is the reason, the shorter the payback period, other things held constant, the greater the project’s liquidity. Apart from this, since cash flows expected in the distant future are generally riskier than near-term cash flows, the payback is often used as an indicator of a project’s riskiness because the longer the payback period the higher is the risk associated with the project (Brigham, 2004) (Fabuzzi, 2003).

A capital budget is very important for a business. It is a heated subject because a decision about capital budgeting can help the business to determine if the proposed investments or project are worth taking or not. There are two things that a business has to take into consideration when it is making a capital budget decision. First there are financial decisions that have to be made. Second, there is an investment decision that is also

Capital budgeting decisions involve investments requiring large cash outlays at the beginning of the life of the project and commit the firm to a particular course of action over a relatively long period of time. As such, they are costly and difficult to reverse, both because of: (1) their large cost and (2) the fact that they involve fixed assets, which cannot be liquidated easily.

The payback period allows an analyst to evaluate the duration it takes for the company to generate dollar returns that pay back the initial cost of the investment. The positives of this approach are that it is fairly easy to understand by both management and

Payback period is the simplest method of the capital budgeting. It does represent the actual amount of period needed for the cash flow that is produced by the investment in repaying back the cost of the original investment. The advantage of this analysis is that it has the provision of insight into liquidity of the investment. Unfortunately, this analysis only includes cash flow payments only within the payback period but not those that are beyond(Hofstrand, 2013).

One advantage of the payback period method of evaluating investment opportunities is that it provides a rough measure of a project 's liquidity and riskiness.

The formula for the payback method is simplistic: Divide the cash outlay (which is assumed to occur entirely at the beginning of the project) by the amount of net cash flow generated by the project per year (which is assumed to be the same in every year). ("Payback Period Formula - AccountingTools,"

The PAYBACK technique is based on cash flows and it measures the time which is required for a proposal’s initial cash outflow to equal its cash inflow generated by the investment, the solution is expressed in years and month or days.

There are major decisions that financial advisors have to make in their daily lives. The first decision is investing decision which is capital budgeting decision. Capital budgeting is when a firm invests its funds in wanting fixed and current assets. This is a decision based on fixed assets taken. There are so many factors that affect investing capital budgeting like cash flow, return on investment, risks involved, and investment criteria. Capital budgeting has many important reasons such as long term growth, large amounts of funds involved, risks involved and permanent decisions (Samiksa).

Using the payback method, Proposal A has a payback period of 6 years and 3 months, as calculated using the formula:

As part of the portfolio management system, a selection criterion is used to determine which projects are most in accord with the organizations mission. Selection criteria is usually either financial or non-financial. In the example provided we are considering which project will meet the needs of high annual cash flow for the small startup company. Using the financial criteria for selection we will employ the payback model, which allows for the direct assessment of future cash flows. This model measures the time it will take for the recovery of the project investment (Larson & Gray, 2011). The limitations of this model are the assumed cash flow during only the investment period, the exclusion of profitability, and the effect of the time value of money (Murphy, 2016).

Payback period calculates the period in which the initial amount invested in the project is recovered.

***Tim must explain to the board that Payback Method does not consider the cost of the capital (debt/equity) that the project will undertake which is reflected in the cash flow. It only states the length of time the company will be tied up in the project. He should also emphasize that the PBP method ignores the time value of money as well as the cash flows occuring after the payback period.