Business Decision Making Sample Assignment (GC01832)
Table of Contents
1.0 Introduction.
2.0 Calculation of Payback Period and NPV for both projects.
Payback period.
NPV.
3.0 Analysis and practical implication. 6
3.1 Analysis using the benefits and drawbacks of the payback period and NPV.
3.2 Analysis using financial and non-financial factors.
3.3 Practical implication.
4.0 Conclusion.
References.
1.0 Introduction
This paper finds the solution to the capital budgeting problem by calculating the Payback Period and NPV for projects A and B. Secondly; this paper evaluates the analysis as well as the practical implication of the project’s payback period and NPV. The merits and demerits of PBP and NPV are analyzed in this paper.
2.0 Calculation of Payback Period and NPV for both projects
Payback period
The payback period indicates the time to recover the initial investment of a project. Horner (2015) stated that the lower the time of recovering initial investment; the higher the acceptability of the project. It is a traditional method of capital budgeting that not considers the time value of money. Payback period of the project 1 & 2 are shown here:
| Year | Net cash flow after 12% cost of capital £ | Cumulative cash flows £ | Net cash flow after 12% cost of capital £ | Cumulative cash flows £ |
| 0 | (40,000) | (40,000) | (60,000) | 60,000) |
| Year 1 | 7144 | (32856) (-40,000+7144) | 8930 | (51070) (-60,000 + 8930) |
| Year 2 | 9564 | (23292) (-32856+9564) | 15940 | (35130) (-51070+ 15940) |
| Year 3 | 11392 | (11900) (-23292+11392) | 17800 | (17330) (-35130+17800) |
| Year 4 | 12720 | 820 (-11900+12720) | 19080 | 1750 (-17330+19080) |
| Year 5 | 17010 | 17830 (820+17010) | 22680 | 24430 (1750+22680) |
| Year | Net cash flow after 12% cost of capital £ | Cumulative cash flows £ |
| 0 | (60,000) | 60,000) |
| Year 1 | 8930 | (51070) (-60,000 + 8930) |
| Year 2 | 15940 | (35130) (-51070+ 15940) |
| Year 3 | 17800 | (17330) (-35130+17800) |
| Year 4 | 19080 | 1750 (-17330+19080) |
| Year 5 | 22680 | 24430 (1750+22680) |
NPV
NPV stands for Net present value. Brentani (2016) stated that it is the difference between the present value of project cash inflows and the present value of project outflows. Broadbent and Cullen (2015) stated that it is a discounting method of capital budgeting to show how much value is added to a firm after investing in a given project. The value of NPV positive indicates the value added but negative indicates value decrease of the shareholders.
Project A- Motor Software Project
| Year | Cash flow £ | Discount factors (12%) | Present value £ |
| 0 | (40,000) | 1.00 | (40,000) |
| Year 1 | 8,000 | 0.893 | 7144 |
| Year 2 | 12,000 | 0.797 | 9564 |
| Year 3 | 16,000 | 0.712 | 11392 |
| Year 4 | 20,000 | 0.636 | 12720 |
| Year 5 | 30,000 | 0.567 | 17010 |
| Present value | 57830 | ||
| Net present value | 57830 – 40,000 = 17830 |
Project 2- Hardware Project
| Year | Cash flow £ | Discount factors (12%) | Present value £ |
| 0 | (60,000) | 1.00 | (60,000) |
| Year 1 | 10,000 | 0.893 | 8930 |
| Year 2 | 20,000 | 0.797 | 15940 |
| Year 3 | 25,000 | 0.712 | 17800 |
| Year 4 | 30,000 | 0.636 | 19080 |
| Year 5 | 40,000 | 0.567 | 22680 |
| Present value | 84,430 | ||
| Net present value | 84,430 – 60,000 = 24,430 |
3.0 Analysis and practical implication
3.1 Analysis using the benefits and drawbacks of the payback period and NPV
According to Elliott and Elliott (2016), the Payback period indicates that the time needed to cover the initial investment of a project. The benefits of PBP include several fields. The payback period is a popular method for evaluating projects for their easy computation. It considers cash flows not profit. Profit is not always a good measure because it misleads the decision. The financial manager can make better decisions on the basis of PBP (Elliott and Elliott, 2016). In addition; PBP provides information about the liquidity of a business firm by calculating the time period of recovering investment. Additionally; PBP helps to measure the risk of a project. However; the Payback period has several drawbacks including a) it ignores cash flows paid or received after PBP time; b) it does not consider the value of money; c) it gives equal importance to all cash flows (Lanen et. al, 2015). In this paper; the proposed project A has 3.94 years of PBP and B has 3.91 years. Therefore; Project B should be accepted.
On the other hand, Net present value (NPV) is discounting method that is calculated by subtracting the present value of cash inflows and an initial investment of a project (Lanen et. al, 2015). The main benefits of NPV are numerous. Brentani (2016) stated that NPV considers the time value of money. Secondly; it is an absolute calculation of returns. Thirdly; NPV is based on cash flows that help to make good decisions. Fourthly, It considers all the cash flows of the project. Finally; it shows the amount of money added to the firm after investing. However; NPV has drawbacks including that it is hard to calculate and understand; needs the knowledge of cost of capital; and is very difficult to forecast future cash flows. In this paper; the proposed project A has an NPV of £17830 and B has £24,430. The cost of capital rate is 12%. Both projects have positive NPV but A requires less investment only £40,000. For this reason; A should be acceptable.
3.2 Analysis using financial and non-financial factors
Financial factors: Brentani (2016) stated that the financial factors affect the capital budgeting decision because both NPV and Pay Back Period consider the cash flow. The timing of cash flows is an important issue in the capital budgeting problem. The cost factor also is affected the PBP and NPV calculation and decision making. Financial accounting is based on an accrual basis. For this reason; the cost happens presently but the sale or inflows happen in the future. The financial manager must consider the time period of inflows and outflows for taking better decisions on investing most preferable projects after the calculation of PBP and NPV of the projects………………………………….
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