Quiz 8: Budgeting
Payback method refers to the method of evaluating a project by measuring that how much time it will take to recover the initial investment. This method has both advantages and disadvantages. The advantage of this method is that it focuses on risk. The longer it takes to earn back the initial investment then the more risky it would be and vice versa. The disadvantage of payback method is that it does not focus on timing of cash flows and also does not consider overall profitability of investments. The problems with the payback methods are as below: 1. The payback method does not note the superiority of the projects which is clearly a weakness in this method. For example: Consider the following pattern of annual cash flows for two different investments of $1million. In the above table, the profits from both the investments appear to be identical because each of the two has earned a return of $1,200,000 which leaves $200,000 as profit as the initial investment is $1,000,000 of both investments. But investment A receives little cash in the year 1 and in the year 2 whereas the investment B receives bulk cash in year 1. This means that the organization making investments in B can use that bulk amount for another project or can earn interest in a bank account. Therefore, Investment B is superior to investment A but the fact is that payback method does not note this superiority. So, it is the problem with the payback method. 2. This method pays its overall attention on the minimum possible length of time until a project repays its initial investments but it does not consider the overall profitability of the project. For example: Consider the following pattern of annual cash flows for two different investments of $1million. In the above table, in the year 4 investment A has a cash inflow of $3 million and investment B has no cash inflow. The profit of investment A far exceeds than the investment B. But according to payback method, investment A is considered to be an inferior one because it has a longer payback period. So, this is a problem with payback method that it pays its all attention on the minimum possible length of time until a project repays its initial investments.
When cash inflow is coming year - by - year it is required to calculate the present value of cash inflows. In simpler terms Present Value is the current value of the future streams of the cash flows at specified rate. It means that future cash inflows are discounted at specific discount rate. Decision rule: If the NPV is positive or zero, then the project is accepted and if the NPV is negative, then the project is rejected. The estimated expenses and revenues related to the special nurse program are provided by the hospital. It is required to state that whether hospital should accept the program or not. Required rate of return is 12%. Calculate NPV for given cash flows: Present value of cash outflow is $300,000. Net Present Value (NPV) is the difference between the present value of cash inflows and initial investment. From the above calculation the Net Present Value is positive therefore it can be concluded that, hospital should undertake the program.
Capital budgeting refers to the process of determining and evaluating potential investments that are large in nature. These investments include those assets which has a life greater than one year. Capital expenditures are the funds used by the business or organization for the maintenance of physical assets such as industrial buildings, property or equipment. These expenses are made in order to expand the competitive and productive postures of the organization. Separate capital budget is needed because of the following reason: Matching of revenues and expenses may explain that why some assets must be treated as capital items and depreciated over their useful lives however it is necessary to have a separate budget process for capital items. If capital assets would be included in the normal operating budget then it will understate their net benefits and their entire cost would appear in the current year as the asset is purchased in the current year due to which only current-year-revenues will appear in the operating budget. Since, capital asset will be used in the future years also so their revenues would not be fully measured in the one-year operating budget. This will increase the cost of the company for that year then it is possible that the organization would reject that capital item due to its high cost. That is why the items are separated into capital budget as full benefits of items can be considered in comparison to their full costs. .