School of Management
Blekinge Institute of Technology
THE IMPORTANCE OF THE PAYBACK METHOD IN CAPITAL BUDGETING DECISION.
By
Alaba Femi, AWOMEWE & Oludele Olawale, OGUNDELE
Supervisor: Anders Hederstierna
Thesis for the Master’s degree in Business Administration Fall/Spring 2008
THE IMPORTANCE OF THE PAYBACK METHOD IN CAPITAL BUDGETING DECISION.
By
Alaba Femi, AWOMEWE & Oludele Olawale, OGUNDELE
A thesis submitted in partial fulfillment of the requirements for the degree of MBA (Master of Business Administration)
Blekinge Institute of Technology
2008
Supervisor Anders Hederstierna
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Abstract Title: The importance of the Payback method in Capital budgeting decision.
Authors: Alaba Femi,
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From the analysis, the trend showed that the payback method has been prevalent in appraising capital budget decisions in various organizations.
Conclusion: It became evident that the payback method is still often used in organizations all over the world despite its criticism by the academicians, making inference from the analysis of companies in Europe, America and Africa. The importance of the payback method, which includes but not limited to its simplicity, liquidity and risk assessment have made the method to be gaining more awareness in appraising investment opportunity by practicing manager.
Key words: Capital Budgeting, Payback Method, Payback Period, Net Present Value, Internal Rate of Return, Real Options Approach.
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Acknowledgements We would like to express our gratitude to all our loved ones both home and abroad, who have supported and encouraged us through out our MBA studies especially through the tough and rough times. We also owe a special gratitude to God for the grace and ability to complete this programme. Finally, we would also like to thank our supervisor, Assistance Professor Anders Hederstierna for his patience, constructive advice and assistance throughout the duration of this thesis work.
Alaba Femi, Awomewe Oludele Olawale, Ogundele June, 2008
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TABLE OF CONTENTS Abstract………………………………………………………………………………………..iii Acknowledgement…………………………………………………………………………….iv List of
This mini-case provides a review of the methodology and rationale associated with the various capital budgeting evaluation methods such as payback period, discounted payback period, NPV, IRR, MIRR,
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).
©2011 IAM IAM Level 2 Certificate in Principles of Business and Administration • Qualification handbook • 7
26.8 B. Ex. 26.9 B. Ex. 26.10 Topic Understanding payback period Use of return on investment Comparing NPV and required rate of return Net present value computations Computations for payback period Capital investment challenges Net present value and required rate of return Capital budgeting behaviors Net present value analysis Nonfinancial investment concerns Exercises 26.1 26.2 Topic Accounting terminology Payback period 26.3 26.4 26.5 26.6 26.7 26.8 26.9 26.10 26.11 26.12 Learning Objectives 26-3 26-3 26-3, 26-4 26-3 26-3
* Español * العربية * Português * 日本語 * Deutsch Assignment Set- 1 Master of Business Administration-MBA Semester 1MB0038 –
When making capital budgeting decisions, there are various techniques that can be utilised. Ross et al. (2008) describes that the predominant capital budgeting methods used as being the Net Present value (NPV) method, the Internal Rate of Return (IRR) method, the Payback method, and the Accounting Rate of Return (ARR) method. Conversely, Brealey, Myers and Allen (2011) proposes that the NPV and IRR methods are considered prestige compared to the ARR and the Payback Methods, as they take into account the time value of money. Thus, the following project evaluation will focus on using the NPV and IRR methods.
Christ like life experience during any financial capital planning. The most important part during the business financial planning is outweighing risk and return on business investments. Managers should remember to be transparent not hiding any financial exceptions that could alter or change the outcome of the financial statements. Building a professional group that is consistent year by year requires enforcing professional financing standards by put into effect a detail transparent investment and expenditure planning process. The establishment of clear guidelines of budget and projected benchmarks must be discussed before, during and after budget development. It is mentioned that capital budgeting “is a systematic method of allocating financial, physical, and human resources to achieve strategic goals. Companies develop budgets in order to monitor progress toward their goals, help control spending, and predict cash flow and profit” (Inc., 2000). The expertise for a successful final capital budget is a combination of Gods teachings, individual’s expertise and businesses strategic goals.
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.
Although CarHome project can generate positive free cash flow, it offers negative net present value (NPV) when discounted at weighted average cost of capital. This means that the shareholders’ wealth could not be maximised by accepting the project. In general, the company prefer shorter payback period. The discounted payback period of the project is 10.6 years, which is highly above the expected cut-off period of 6 years. On top of that, internal rate of return (IRR) is around 12% - 12.5%, which is below the weighted average cost of capital of 13.24% (as hurdle rate). The business managers are risk averse in nature. They prefer less risk to more risk for a given level of expected return (Pike et al, 2012). Consequently, it is too risky for
These methods are: 1. Payback Method 2. Accounting Rate of Return( ARR) 3. Net Present Value (NPV)
i) The payback method of capital budgeting is the time period where the cash inflows from the project pay back the initial cash outlay. The formula for payback period, when the cash flows are stable is:
Capital budgeting is the most important management tool that enables managers of the organization to select the investment option that yields comprehensive cash flows and rate of return. For managers availability of capital whether in form of debt or equity is very limited and thus it become imperative for them to invest their limited and most important resource in perfect option that could prove to beneficial for the organization in the long run (Hickman et al, 2013). However, while using capital budgeting tool managers must understand its quantitative and qualitative considerations that are discussed below.
The five investment appraisal techniques used for this report are the Accounting Rate of Return (ARR), payback period, Net Present Value (NPV), discounted payback and Internal Rate of Return (IRR). The results of the five investment appraisal techniques may not be similar because of differences in their approaches and calculations. However, it is advantageous to use more than one investment appraisal technique and understand the importance and problems of each method before making a final decision.
Apart from references of other people’s work which were fully acknowledged, I hereby certify that this research work was wholly done by me under the guidance of my supervisor, Mallam Sani Gurowa of Department of Accounting, University of Abuja, Abuja, Nigeria.