Advantages and disadvantages of payback

Guided Response: Review the posts from your classmates and respond to at least two. Compare and contrast the points you and your classmates made regarding the three methods of ranking capital investment proposals. Each response should have a minimum of 100 words.

Giancarlo Marchena

According to Block, Hirt and Danielson (2019), there are three main methods of ranking capital proposals in terms of their financial viability. The first method of capital expenditure assessment is the payback method. The payback method focuses on the time needed to see a return on investment for the initial capital expenditure or how much the capital expenditure will return in a set period of time. This method ranks proposals from quickest rate of return to slowest rate of return when looking at financial viability. Because the payback method focuses on the liquidity of the project or initial investment, it is used by many corporations that depend on swift technological advances to retain or grow their market share. These corporations are liquid dependent because cash at hand is translated to more projects that may lead to gain in the market share. The first drawback of the payback method is that it fails to consider the inflow of revenues outside of the predetermined period being considered. This is particularly important if the capital expenditure has a greater rate of return after the period being considered is over. The second drawback to the payback method is that it does not value the specific time in which return is made during the considered period. Furthermore, if two proposals are made which have the same total net over the time considered, they would be considered equally viable.

The net present value method of evaluating capital is the most widely used method by financial professionals. This method highlights the value of each inflow and outflow of capital associated with the project at a discounted rate determined by the when the transaction was made. Furthermore, each transaction has the weighted average cost of capital applied to it in order that the time of the transaction is taken into consideration for the analysis of financial viability. The major advantage of this method is that the time of inflow or outflow is taken into consideration as the rate of return of capital should be weighed out when the entity is dependent on having cash at hand. Secondly, net present value can presently be widely used as the main mathematical functions for this method are already built into programs like Microsoft Excel.

According to Hayes (2020), the internal rate of return method of evaluating capital measures capital expenditures in terms of profitability as a percentage calculation against the initial investment. The biggest consideration in using this method is that the net present value of all inflows and outflows are equal to zero thus allowing for a development of a discounted rate. That discounted rate is used to infer the profitability of one investment over any other such that the project with the highest internal rate of return should be the most favorable (keeping initial investment cost equal). One of the main advantages to using the internal rate of return is that it allows the easy translation of the project annual growth benefit to the entity’s growth expectations. A limitation of this method is that can very seldom be used on its own. There may be an instance where the internal rate of return is low but net present value is high. In this case, the year over year profitability may low but the value add to the organization may be high.

References

Block, S. B., Hirt, G. A., & Danielson, B. R. (2019). Foundations of financial management (17th ed.). Retrieved from https://www.vitalsource.com/ (Links to an external site.)

Hayes, A. (2020, April 27). Internal Rate of Return – IRR. Retrieved May 1, 2020, from https://www.investopedia.com/terms/i/irr.asp (Links to an external site.)

James Varughese

Hello Class,

The three primary methods to rank capital investment are the payback method, net present value, and internal rate of return (Block, Hirt, & Danielsen, 2019). In the payback method, the time required to recover the initial investment is used to assess capital investment (EduPristine, 2018). In other words, capital investments are evaluated based on the time required to generate income to recover the initial investment. The main advantage of the payback method is that it is a simple and easy way to compare different capital investment projects and select the project with the shortest payback time (E Finance Management, 2019). On the other hand, the disadvantage with the payback method is that it does not consider the time value of money, the focus is only on income generated during the recovery period and it ignores the profitability from the investment (E Finance Management, 2019). In the case of the net present value (NPV) method, the sum of the present values of all outflows and inflows related to the project are considered. The present values of the cash inflow are compared to the original investment. If the difference between the two is positive, then the investment proposal is selected or rejected based on the findings (EduPristine, 2018). The advantage of the NPV method is that it considers the time value of money, it also takes into consideration the cost of capital and the risk with future projections (Woodruff, 2019). On the other hand, the disadvantages of the NPV method is that the cost of capital for investment is estimated which affects the decision-making process. NPV method is not applicable for comparing projects with different life spans (Woodruff, 2019). Lastly, in the case of internal rate of return (IRR) method, the focus is on the profitability of investment; cash inflow and outflow through the lifetime of the project are taken into consideration and the net present value for all cash flow is equal to zero (Hayes, 2020). The advantages of (IRR) method are that it considers the time value of money and takes into consideration the profitability of the project over the entire economic life of the project. Also, there is no need to estimate the cost of capital for the IRR method (Accountlearning, 2020). On the other hand, the disadvantages of the IRR method are that the IRR method gives importance only to profitability but does not focus on the earliest recovery of capital. IRR method also assumes that the earnings are reinvested at the internal rate of return for the lifetime of the project (Accountlearning, 2020)

Reference:

Block, S. B., Hirt, G. A., & Danielsen, B. R. (2019). Foundations of financial management (17th ed.). Retrieved from https://www.vitalsource.com/ (Links to an external site.)

Accountlearning. (2020, May 9). Retrieved from Advantages and Disadvantages of Internal Rate of Return Method: https://accountlearning.com/advantages-disadvantages-internal-rate-return-method/ (Links to an external site.)

E Finance Management. (2019, May 31). Retrieved from Advantages and Disadvantages of Payback Period: https://efinancemanagement.com/investment-decisions/advantages-and-disadvantages-of-payback-period (Links to an external site.)

EduPristine. (2018, February 7). Retrieved from Capital Budgeting: Techniques & Importance: https://www.edupristine.com/blog/capital-budgeting-techniques (Links to an external site.)

Hayes, A. (2020, April 20). www.investopedia.com. Retrieved from Internal Rate of Return – IRR: https://www.investopedia.com/terms/i/irr.asp (Links to an external site.)

Woodruff, J. (2019, January 25). Smallbusiness.chron.com. Retrieved from Advantages & Disadvantages of Net Present Value in Project Selection: https://smallbusiness.chron.com/advantages-disadvantages-net-present-value-project-selection-54753.html (Links to an external site.)