Table of Contents
2.0 Payback Period.
3.0 Net Present Value.
4.0 Evaluation of the calculated results and making the final decision.
According to Fisher (2017), capital budgeting can be called the process of evaluating projects before final selection, especially for long-term investment. XYZ plc is a hotel chain business and taking a decision to launch Software or a Laundrette project. This assignment describes the PBP and NPV for projects and states the advantages as well as disadvantages of the capital budgeting techniques including PBP and NPV.
2.0 Payback Period
Gitman (2014) stated that the Payback period can be referred to as the duration of coming back the beginning cost of a project. The payback period is a good indicator of a project’s feasibility. The formula of PBP is PBP =
Project A-Software Project
|Year||Cash flows (£)||Balance (£)|
From the calculation of project A’s PBP, it has been found that the beginning investment will be recovered within.
Project B- Launderette Project
= 3 years and 1.5 months
3.0 Net Present Value
According to Houston (2016), Net present value is one kind of discounting method of capital budgeting. Among the all techniques of capital budgeting, NPV is considered the most suitable and acceptable technique in the project selection. Halley (2016) stated that the NPV is a method by which it can be identified that how much value is added with the shareholder’s wealth due to adopt the project. The formula of NPV is= NPV= Present Value of cash inflows – Present Value of cash outflows
Project A-Software Project
|Discount factors (11%)||Present value|
|Net present value||£159296 – £100,000 |
From the calculation of project A’s NPV, it has been found that the project value is positive and increased the shareholders’ wealth by £59296.
Project B- Laundrette Project
|Discount factors (11%)||Present value|
|Net present value||£185173– £120,000 |
From the calculation of project B’s NPV, it has been found that the project value is positive and increased the shareholders’ wealth by £65173.
4.0 Evaluation of the calculated results and making the final decision
Advantages and disadvantages of PBP and NPV
Brigham (2016) stated that the Payback period is an easy calculation of finding the duration of collecting the beginning investment from a project. Before selecting a project, an investor must identify the time of recovering the beginning investment that leads to taking a better decision of project selection. Jim Woodruff (2019) mentioned that the PBP technique has some benefits including a) a project manager can easily calculate the PBP of several projects within a short period of time; b) the calculation of PBP requires less experience and knowledge c) PBP is calculated on the basis of cash flows that don’t mislead the decision.
On the contrary, the PBP technique has some drawbacks including a) PBP is not a discounting method by which time value of money is avoided; and b) it is not considered the receipt after the PBP period that can mislead the decision of accepting the project. From the calculation of project A’s PBP, it has been found that it will get back its beginning investment within 3 years and 1.09 months. From the calculation of project B’s PBP, it has been found that the beginning investment will be backed within 3 years and 1.5 months. Independent project suggests that accept project. However, a mutually exclusive project indicates that XYZ Company can accept only one project which has a lower PBP which means Project B.
Gitman (2014) noted that net present value is a popular method of capital budgeting due to its charismatic features. This method has eliminated the drawbacks of PBP and helped to make better decisions at the time of project selection. Jim Woodruff (2019) mentioned that this method has several benefits including a) it considers the time value of money; b) it does not avoid any cash flows of a project that helps to identify the better outcome of the calculation and c) NPV helps to show the exact amount that adds with the shareholder’s wealth.
However, some drawbacks are attached with the Net present value method including a) extremely hard calculation; b) require huge knowledge and c) it is an assumption method. Halley (2016) stated that in the case of the independent project; accept all projects which have positive NPV. The decision criteria are a) NPV≥0, accept the project; and b) NPV≤ 0, reject the project. It has been found both projects have positive NPV, therefore, XYZ company can accept both projects for investing funds. On the contrary, a mutually exclusive project indicates that XYZ Company can accept only one project which has a higher NPV which means project B. It has been found both projects have positive NPV, therefore, XYZ company can accept both projects for investing funds. On the contrary, a mutually exclusive project indicates that XYZ Company can accept only one project which has a higher NPV which means project B.
Use of financial/non-financial factors and their implication
According to Halley (2016), the financial factors influence the decision-maker directly because the calculation of PBP and NPV depends on the financial issues. The financial factors can be changed the decision of choosing a project in capital budgeting. The factors include a) cash flows (outflows and inflows) b) depreciation rate, c) rate of inflation and d) discounting or cost of capital rate. Every manager has to take these factors seriously for evaluating and taking the best project for firms’ development. Halley (2016) mentioned that a decision-maker is also influenced by non-financial factors at the time o taking the final decision of project selection.
It includes rules and regulations, cultural issues, social factors, employee nature, customers demand and others (Houston, 2016). The only financial technique of capital budgeting can’t generate effective decision to accept a particular project, Therefore, the practical business field appeal that the financial managers should consider and analyzes different non-financial factors along with both PBP and NPV to make the best decision of project selection. Houston (2016) stated that the NPV method is practically affordable in all types of project selection.
In summary, XYZ can take a plan to launch a project of Software development or Laundrette project and it has found that both projects have favorable payback period and net present value. Since the company can select only one project, project B is more suitable because it adds more value to the firm than project A. It has also been found that both PBP and NPV have benefits and drawbacks but still, NPV is more accepted by the financial decision-makers.