ident of CU that requires an initial 000 and expected to provide tash benefits A
ID: 2503846 • Letter: I
Question
ident of CU that requires an initial 000 and expected to provide tash benefits After laa the 10 years savings associated with the system are as the payback for the system As lume that the company has a policy of with yearsories Should the stem be purchased Catoulate the NP and the IRR (use Excel to calcu l the RRO the project should the intern be ed? What if the system does not meet the The project manager reviewed the projected and pointed out that two been mised. the would have a salvage value of s500,000 at the end products produced with the new sytem would by30pe tent, leading to ntown of $180.000. this new informaton. aloulate the payback period. NPV and RR Payback Method vs. profitability enbeet man and would like to have someExplanation / Answer
Capital budgeting decisions are among the most important decisions a business owner or manager will ever make. Which assets to invest in, which products to develop, which markets to enter, whether to expand -- these are decisions that literally make the difference between success and failure. Businesses employ an array of methods to help them make such decisions. Among the most popular are the net present value method and the payback period method.
Under the net present value method, a business estimates all the cash flows, both positive (revenue) and negative (costs), of pursuing a project, now and in the future. It then adjusts, or "discounts," the value of future cash flows to reflect what they're worth in the present day. It makes this adjustment using a "discount rate" that takes into account inflation, the risk of the project and the cost of capital -- either interest paid on borrowed money or interest not earned on money spent to pursue the project. Finally, it adds up the present values of all the positive and negative cash flows to arrive at the net present value, or NPV. If the NPV is positive, the project is worth pursuing; if it's negative, the project should be rejected. When deciding between projects, choose the one with the higher NPV.
Under the payback period method, a company estimates how much it will cost to launch the project and how much money the project will generate once it's up and running. It then calculates how long it will take the project to "break even," or generate enough money to cover the startup costs. Companies using the payback period method typically choose a time horizon -- for example, 2, 5 or 10 years. If a project can "pay back" the startup costs within that time horizon, it's worth doing; if it can't, the project will be rejected. When deciding between projects, choose the one with the shorter payback period.
The payback period method has some key weakness that the NPV method does not. One is that the payback method doesn't take into account inflation and the cost of capital. It essentially equates $1 today with $1 at some point in the future, when in fact the purchasing power of money declines over time. Another is that the payback method ignores all cash flows beyond the time horizon -- and those cash flows may be substantial. Big moneymakers, after all, sometimes take a while to get going. On the other hand, the big drawback of the NPV method lies in its assumptions. If you don't get your estimate of the discount rate correct, your calculation will be off -- and you won't know it until the project turns into a big money-loser.
Many businesses use a combination of methods when making capital budgeting decisions. A company could use the payback period method to narrow down its options, then apply the NPV method to identify the best of the remaining projects. Or it could use the NPV method to separate the "winners" from the "losers" among possible projects, then look at payback periods to see which projects return their costs more quickly.
In every business, it is crucial to evaluate the value of a proposed project before actually investing on it. There are a number of solutions to evaluate this on a financial perspective and among them are Net Present Value (NPV) and Payback methods. These two can measure the sustainability and value of long-term projects. However, they differ in their computation, factors, and thus vary in terms of limitations and benefits.
NPV, also known as Net Present Worth (NPW), is a standard method for using the time value of money to appraise long-term projects. It calculates a time series of cash flows, both incoming and outgoing, in terms of currency. NPV equates to the sum of the present values of the individual cash flows. The most important thing to remember about NPV is
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