Advantages of Payback Method and how it compares with Discounted Cash flow

• It is Simple Payback is easy to calculate. Payback method looks at the number of years which make it simple and easy to understand.
• Offers Quick Evaluation Determining which projects can generate fast returns is important to companies especially those with limited resources. Managers of such companies use this method to make a quick evaluation regarding projects with the small investment and short payback period.
• It shows the importance of considering liquidity when making investment decisions.
• It offers the shortest approach to calculating capital expenditure.

(Any 2 points well explained for 2 marks)

Disadvantages of the Payback Method and how it compares with Discounted Cash flow

• Ignores the time value of money: The most serious disadvantage of the payback method is that it does not consider the time value of money. Cash flows received during the early years of a project get a higher weight than cash flows received in later years. Two projects could have the same payback period, but one project generates more cash flow in the early years, whereas the other project has higher cash flows in the later years. In this instance, the payback method does not provide a clear determination as to which project to select.
• Neglects cash flows received after payback period: For some projects, the largest cash flows may not occur until after the payback period has ended. These projects could have higher returns on investment and may be preferable to projects that have shorter payback times.
• Ignores a project’s profitability: Just because a project has a short payback period does not mean that it is profitable. If the cash flows end at the payback period or are drastically reduced, a project might never return a profit and therefore, it would be an unwise investment.
• Does not consider a project’s return on investment: Some companies require capital investments to exceed a certain hurdle of rate of return; otherwise the project is declined. The payback method does not consider a project’s rate of return.

(Any 2 points well explained for 2 marks)

The key stages in the capital investment decision-making process are identifying investment opportunities, screening investment proposals, analyzing and evaluating investment proposals, approving investment proposals, and implementing, monitoring and reviewing investments.

Identifying investment opportunities
Investment opportunities or proposals could arise from analysis of strategic choices, analysis of the business environment, research and development, or legal requirements. The key requirement is that investment proposals should support the achievement of organizational objectives.

Screening investment proposals
In the real world, capital markets are imperfect, so it is usual for companies to be restricted in the amount of finance available for capital investment. Companies therefore need to choose between competing investment proposals and select those with the best strategic fit and the most appropriate use of economic resources.

Analysing and evaluating investment proposals
Candidate investment proposals need to be analyzed in depth and evaluated to determine which offer the most attractive opportunities to achieve organizational objectives, for example to increase shareholder wealth. This is the stage where investment appraisal plays a key role, indicating for example which investment proposals have the highest net present value.

Approving investment proposals
The most suitable investment proposals are passed to the relevant level of authority for consideration and approval. Very large proposals may require approval by the board of directors, while smaller proposals may be approved at divisional level, and so on. Once approval has been given, implementation can begin.

Implementing, monitoring and reviewing investments
The time required to implement the investment proposal or project will depend on its size and complexity, and is likely to be several months. Following implementation, the investment project must be monitored to ensure that the expected results are being achieved and the performance is as expected. The whole of the investment decision-making process should also be reviewed in order to facilitate organizational learning and to improve future investment decisions.

(5 points well explained @ 2.5 marks=10 marks)

The time value of money relates to the return required by investors and has three main elements:

Delayed Consumption
There is an opportunity cost involved with the investment of funds. Generally, the value of GH¢1.00 now is greater than the value of GH¢1.00 in one year’s time since investors have to give up present consumption. An investor will give up present consumption for the potential of higher future consumption i.e. they need to be rewarded for giving up certain current consumption for certain future consumption.

Inflation
If there is inflation, then investors also need to be compensated for the loss in purchasing power as well as for time.

Risk
The promise of money in the future carries with it an element of risk. The payout may not take place or the amount may be less than expected. An investor therefore needs to be compensated for time, inflation and also risk.

The objective of investment within a company is to create value for its owners. Investors have alternative uses for their funds and therefore have an opportunity cost if money is invested in a corporate project. Investments therefore must generate enough cash for all investors to receive their required returns.

(3 well explained points @ 2 marks each = 6 marks)

Pay Back Period is defined as the period, usually expressed in years, which it takes the cash flows from a capital investment project to equal the cash flows generated.

Decision:
Semi-automated plant is considered more suitable because of PBP of 4 years as against 5 years for an automated plant.

Decision:
It is advisable to select automated plant that gives a higher NPV though the capital requirement of the plants differs.

• It uses the time value of money.
• It uses the cost of capital.
• Uses cash flow instead of accounting profit.
• Considers the entire life of the project.                                                                 (Any 2 points)

The net investment should be 78,000. This is because the receipt on disposal of old asset should be deducted from the cost of the new machine.
The resale value of the machine is GH¢ 8,000.

Candidates can use annuity due formula to determine the NPV
Using Annuity Due, NPV is obtained as:
= – Co + C x AF + C/ (1+ r) 𝑛
= – 78,000 .00 + 30,000.00 x 3.038 + 8,000.00 / (1.12) 4
= – 78,000.00 + 91,140.00 + 5,084.14
= 18,224.14

ALTERNATIVE SOLUTION 1:

ALTERNATIVE SOLUTION 2:

Decision:
The NPV is positive and so the project is expected to earn more than 12% per annum and is therefore acceptable.

Justifications for the use of Payback Method

• It is considered useful when firms face liquidity constraints and require a fast payment of their investments.
• It serves as a simple first level screening device that indentifies those projects that should be subjected to more rigorous investigations.
• It provides a rough measure of risk, based on the assumption that the longer it takes for a project to pay for itself, the riskier it is.

Justification for the use of ARR

• ARR is a widely used financial measure of managerial performance. So managers are likely to be interested in how any new investment contributes to the business units’ overall accounting rate of return.

Limitations of Payback Method

• It ignores the time value of money
• It ignores cash flows that are earned after the payback period

Limitations of ARR

• The ARR fails to take into consideration the time value of money
• It relies on a percentage return rather than an absolute value