COST OF CAPITAL BUDGETING 4
Thepayback period implies the time, expressed in years, of the project’sinitial cash outflow until that period when the cashinflows matchthe cash outflowemployed(Brigham, 2008).The strengths of payback period include, first it is a simplemethod of evaluation because it is an easily understood concept.Moreover, payback allows managers to make quick projects’evaluation based on small investment without making thorough economicanalysis. The weaknesses includeit assumes money time value because it does not focus on the cashinflows from projects. Payback isusedas first tool forevaluating projects. The acceptance criterion of payback is that themanagershould accept the project with the shortest time of payback andreject if the period is greater than maximum acceptable period ofpayback
NetPresentValue is whereby the cash flows arecomputedthrough discounting based on required return rate(Smidt, 2014).Its strength includes,unlike payback, NPV considers the time money factor (value). Theweaknesses of NPV include, it requires projection, which may not beaccurate because it involves estimation of the dollar value and itsfuture income. Moreover, although NPV depends on percentage return interms of calculation, the project’s actual returnis not revealed. It isusedwhen the manager wants to know the future money value based oncurrent value. Thedecisionrule is that accept if NPV≥0 and reject if NPV<0.
Internalrate of return is the rate of discount that forces the NPV of aproject to equal zero. Its strengths include, it considers all cashflow and time value of the money. Its weaknesses include abnormalcash flows results into multiple IRRs, incorrect cash flows leads towrong IRRand assumes the reinvest rates. Itis applied in situations with more than a projectto be evaluatedandrelated. The decision rule is similar to that of NPV.
Profitabilityindex implies the payoff ratio of a project proposed(English, 2011).Itsstrengths include it is easy to understand, considers the time valueof the money while weaknesses include estimationsof the cost of capital prior to its calculation and incorrectcomparisons when weighing projects, which are mutually exclusive.It is used to rank projects because it quantifies value perinvestment unit. In terms of decision rule, it is greater than one,then the projectis accepted and if it is below the set optimum, the project isrejected.
Brigham,E. (2008). Principlesof Finance.United States of America: Cengage Learning.
English,P. (2011). CapitalBudgeting Valuation: Financial Analysis for Today`s InvestmentProjects.Canada: John Wiley & Sons.
Smidt,S. (2014). AdvancedCapital Budgeting: Refinements in the Economic Analysis of InvestmentProjects.New York: Routledge.