ASSIGNMENT 3

Assignment 3

Assignment 3

Introduction

There are various financial appraisal techniques to choose from, ranging from simple to sophisticated techniques. These techniques help the managers to evaluate the effectiveness of certain projects, helps to predict their return on investment over a period of time, and aid the management in decision making. Over the years, the capital budgeting or financial appraisal techniques have evolved. The modern techniques use time value of money concept in evaluating the return from a project. These techniques include payback period, discounted payback period, net present value, and internal rate of return.

Task 1

a)

Payback period

Payback period refers to capital budgeting concept in which period is calculated that recover the original investment of the project. There are few advantages of payback period and certain disadvantages too. Advantage is of payback period are; it is easy to use, and one can apply payback period with minimal financial knowledge, and it give a business a time frame in which its project will be recovering its original investment. Disadvantage of payback period includes as payback period cannot provide the clear picture as it does not include the factor of the time value of money. Also, payback period is concerned with the recovery of initial investment of the project and does not account the future returns. It also does not provide complete decision criteria for the firm regarding the value enhancement to firm (Gropelli & Nikbakht, 2006, pp. 158-159). Payback period of all three projects are as follows:

Project A

Year

Outflow

Inflow

Payback Period

0

Initial Investment

-£ 4,100,000.00

1

£ 2,100,000.00

2

£ 1,850,000.00

3

£ 1,500,000.00

2.10 Years

4

£ 1,250,000.00

5

£ 960,000.00

After applying payback period it is found that the project is completing its cost in 2.1 years.

Project B

Year

Outflow

Inflow

Payback Period

0

Initial Investment

-£ 4,900,000.00

1

£ 1,720,000.00

2

£ 1,853,000.00

3

£ 1,789,000.00

2.74 Years

4

£ 1,690,000.00

5

£ 1,790,000.00

It is found that Project B will take 2.74 years to payback its cost which found by calculating payback period.

Project C

Year

Outflow

Inflow

Payback Period

0

Initial Investment

-£ 5,000,000.00

1

£ 960,000.00

2

£ 1,429,700.00

3

£ 1,612,000.00

4

£ 1,740,000.00

3.57 Years

5

£ 1,906,000.00

After calculating the payback period of project C it is found that project C will take 3.57 years to repay its initial cost.

By analysing all three project proposal under payback period it is found that the project 1 is more appropriate for investment when it is analyzed by payback period.

Discounted payback period

Discounted payback period is similar to payback period except it takes present value of cash flows rather than future values as used in payback method. In discounted payback period, time value for money is considered while evaluating capital budgeting project and also involves cost of capital which considers the risk factor also. However, as discounted payback period it does not provide concrete decision criteria for firm regarding value enhancement of the firm. It also ignores future cash flows after the payback period. The cost of capital used to consider risk is an estimate value (Megginson & Smart, 2008, pp. 334-335). Discounted payback period of all three projects are computed as follows:

Project A

Year

Outflow

Inflow

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