I need you to answer separately two parts. Part 1 This week’s discussion question looks at capital budgeting and risk analysis. I always say that perception is everything as many of you will take this question into different concepts. Why is capital budgeting important? I have to say that NPV and the Payback Period have been the most important for me. This is because knowing the present value makes a difference as a dollar today is worth more than a dollar tomorrow. I tend to invest when small business owners are trying to get their business off the ground. The payback period is essential as the longer you go without getting paid the more risk you are taking as you are most likely not going to get paid if the time frame is too long. Not to mention the longer you take to get paid the more money you are actually losing. I am curious to know how many of you are investors? How much of a risk-taker are you? For those that do not invest or that are not really risk-takers, there are apps that will help you that I can recommend. Here is a visual of the techniques that we shall discuss. https://www.wallstreetmojo.com/capital-budgeting-techniques/ Since the pandemic, companies were forced to change the way they think and handle their finances. I think you will find the following article interesting as well. https://www.wsj.com/articles/companies-turn-to-zero-based-budgeting-to-cut-costs-during-the-pandemic-11592431029?mod=searchresults&page=1&pos=3 Part 2 respond to one student A capital project is typically described as the purchase or investment in a fixed asset that will last more than one year by definition. Companies often report current projects as an expense on the income statement rather than as a capitalized cost on the balance sheet because they last less than a year. Any large-scale, expensive project, such as purchasing equipment for a new assembly line or building a new warehouse, is considered a capital project. Each project must be able to demonstrate that it will pay for itself while also improving production, lowering expenses, or providing other unique business benefits. For the purposes of capital budgeting, the payback period is easily defined. The payback period is the amount of years it takes for a capital project’s original investment to be repaid from the cash flows it generates. A capital project could include the purchase of a new plant or building, as well as the purchase of new or replacement equipment. Depending on their industry, most companies specify a cut-off repayment term, such as three years. In other words, if the payback time is less than three years, the company will buy the asset or participate in the project. It would not, if the payback took four years because it exceeds the firm’s three-year payback threshold. What the investment earns in cash each year is the net yearly cash inflow. If this was a replacement investment, such as a new machine replacing obsolete equipment, the annual cash inflow would become the investment’s incremental net annual cash flow. The project pays for itself a year (plus a few months) before the cash flow starts to become positive. A number of flaws exist in the payback period formula. If the equipment lives differ by many years, for example, adding in the economic lives of the two machines could yield a drastically different result. One shortcoming of payback is that it does not account for the usable lives of the equipment or facility under consideration. The fact that the repayment period ignores the time value of money is maybe an even more serious criticism. Cash inflows from projects that are expected to be received in two to ten years, or beyond, are given the same weight as cash inflows expected in year one. The method produces a potentially more advantageous outcome than the reality would imply due to the economic risk involved with the passage of time to collect the money. The payback period is inadequate for a project with erratic financial flows. The payback period is a very worthless capital planning strategy if a project’s cash flows are uneven unless you take the further step of applying a discount factor to each cash flow. The key benefit of the payback time formula is that it produces a “quick and dirty” answer that gives management a general estimate of when the project will pay off the initial investment. Despite the availability of more innovative ways, management may prefer to stick with this tried and effective method for the sake of efficiency. Payback Period: Making Capital Budgeting Decisions (thebalancesmb.com)
