Capital Investment Appraisal

Payback period is the length of time required for the net cash inflows to cover the initial cost of the capital project.

Advantages

• quickest and easiest to calculate
• focus on cash - which is normally scarce
• emphasis on speed of return
• straightfoward to comapre to other projects

Disadvantages

• doesnt take into account time value of money
• may encourage short term thinking
• ignores cash flows which arise after payback period
• ignores qualitative factors

Year   Cash Inflow £   Cash Outflow £   Net Cash Flow £   Cumalative Cash Flow £

0                -                    (110'000)               (110'000)                   (110'000)

1           55'000                   35'000                  20'000                        (90'000)

2           90'000                   30'000                  60'000                        (30'000)

3          120'000                  40'000                  80'000                         50'000

4          120'000                  40'000                  80'000                        130'000

5          120'000                  35'000                  85'000                        215'000

Payback period = 2 years + (30'000/80'000) *12 = 4.5 months

                          = 2 years and 4.5 months

Net Present Value is the calculated discounted cash flow - it calculates the monetary value of the project's future cash flows

Advantages

• takes into account time value of money
• looks at all cash flows of the project
• managers able to reject projects with negative NPV

Disadvantages

• more complicated method - users may find it hard to understand
• difficult to select discount rate i.e. 5%, 10%
• the NPV calculation is very sensitive to the intital investment cost

Year   Net Cash Flow £   Discount Factor £     Discounted Cash Flow £

0        (110'000)                       1.000                         (110'000)

1           20'000                         0.909                           18'180

2           60'000                         0.826                           49'560

3           80'000                         0.751                           60'080

4           80'000                         0.683                           54'640

5           85'000                         0.621                           52'785

Net Present Value =                                                 125'295