Capital Investment Appraisal

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Payback Period

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
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Payback Period Example

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)

          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

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Net Present Value

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
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Net Present Value Example

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

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

1           20'000                         0.909                           18'180

          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

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