Problem:
A company is considering two projects, Project A and Project B with different cash flows as disclosed in the table hereunder:
However, since the company has a limited budget, it can only invest in one of the project. Thus, the managers of the company take the help of capital budgeting techniques, NPV analysis and Payback Period.
NPV Analysis:
The NPV is the sum of the present values of all the expected incremental cash flows if a project is undertaken. The discount rate used is the firm’s cost of capital, adjusted for the risk level of the project. In other words, the NPV is the present value of the expected inflows minus the initial cost of the project and is calculated using the following formula:
NPV = CF0 + CF1 + CF2 + .. + CFn (1+k)0 (1+k)1 (1+k)2 (1+k)n
n = å CFt t=0 (1+k) t
Where, NPV= net present value CFt = cash flow occurring at the end of year t (t = 0, 1,.. n). n = life of the project
k = cost of capital
Calculative Outcome:
NPV of Project A: -2000+ 1000/(1.1) + 800/(1.1)2 + 600/(1.1)3 + 200/(1.1)4
= $157.44
NPV of Project B: -2000+ 200/(1.1) + 600/(1.1)2 + 800/(1.1)3 +1200/(1.1)4
= $98.36
Since, Project A has higher NPV, it is rationale to accept this project.
Pros of NPV Analysis:
- It considers the time value of money in all the calculations.
- It considers the total benefit of an investment proposal over its lifetime.
- Any changes in the discount rate used in the calculations can easily be involved in the analysis.
- NPV allows easy comparison of multiple projects and thus, helping in appropriate selection of the profitable projects.
Cons of NPV Analysis:
- The technique fails in comparing the project with different lives
- NPV analysis is a costly as well as complex capital budgeting technique requiring appropriate training and theoretical know-how of the method to ensure accurate analysis.
Payback Period:
The payback period is the number of years it will take for a project to recover the initial amount of investment in the project. This technique of capital budgeting is one of the simplest to calculate but has a vital importance as it helps the finance managers to undertake the decision relating to a project as long payback periods are generally avoided. Below is the formula for calculating the payback period:
Payback period: Full years until recovery+ (unrecovered cost at the beginning of last year/ cash flow during the last year)
Calculative Outcome:
Payback Period of Project A: 2+ 200/ 600= 2.33 years
Payback Period of Project B: 3 + 400/1200= 3.33 years
Since, Project A has lesser payback period, it is rationale to accept this project.
Pros of Payback Period:
- The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects.
- It is simple, intuitive, and considers cash flows rather than accounting profits.
- It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such as Net Present Value and Internal Rate of Return.
Cons of Payback Period:
- One major weakness of the payback method is that the appropriate payback period is a subjectively determined number.
- It do not consider the cash flows after the payback period.
- It also fails to consider the principle of wealth maximization because it is not based on discounted cash flows and thus provides no indication as to whether a project adds to firm value.
- Payback fails to fully consider the time value of money.
Conclusion:
On comparing the pros and cons of each of the capital budgeting method and considering the needs of modern day corporate who depend heavily on time value of money concepts, it will be most important to use NPV analysis to support our decision on accepting Project A. Important to note that although a second version of Payback Period, i.e. Discounted Payback Period includes the time value of money concept in the calculation by discounting the cash flows at the project’s required rate of return, however still this method do not consider the cash flows beyond the payback period. Hence, just like payback period, even discounted payback period is not as reliable as NPV Analysis.
Works Cited
Meritt, C. (n.d.). Net Present Value Method Vs. Payback Period Method. Retrieved May 22, 2014, from http://smallbusiness.chron.com/net-present-value-method-vs-payback-period-method-61578.html
Net Present Value. (n.d.). Retrieved May 22, 2014, from Themanagementor.com: http://www.themanagementor.com/enlightenmentorareas/finance/mgr/NetPresentVal.htm
