Why Is the Investment Appraisal Process so Important free essay sample

This concept of a target payback could be employed in the case of projects A and B above. The payback target is 3 years, so project B should be accepted because it pays back after 2 years 9 months where as project A payback only after 3 years and 4. 8 months which is more than the target. The longer the time period for receipt of cash, the greater the risk. C) What are the criticisms of the payback period? Payback is the number of years it takes to recover the initial investment. It is expressed in time or years. It is normally defined as the period, usually expressed in years, which it takes the cash inflows from an investment project to equal the cast outflows. There are three important criticisms of the payback period method. The first is clearly fundamental and relates to the fact that cash flows after the payback period are ignored. So it could be the case that whilst a project produces a large net cash flow (i. We will write a custom essay sample on Why Is the Investment Appraisal Process so Important? or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page e. , where cash inflows significantly exceed outflows), they are generated in the later part of the project and may be ignored as this is after the payback period. For example, in the case of project A and B in this question , project B was preferred because of its shorter payback period, but overall project A generates more cash inflows, totaling ? 2,10,000 as compared to only ? 2,00,000 in the case of project B. However, project A`s cash inflows were mainly earned in the later years. The second criticism of the payback method is that it relates to the method not taking account of the time value of money, similarly to the ARR. However, it does not have value in situations where the useful life of the project is short and difficult to predict. Japanese firms, particularly in consumer electronics, use the payback method when evaluating new products since the product life cycle can be quite short and a new product can be made unexpectedly obsolete by changes in technology. For example, imagine we have to choose between two alternatives that each require an initial investment of ? 4000. Option A returns ? 1000 at the end of fourth year. Option B returns ? 4000 at the end of fourth year. NPV, Net Present Value, allows us to value a company’s assets at their correct current value, normally end of the year and when the accounts are prepared. The calculation of NPV takes into account the assets original cost, less all accumulated depreciation allowed against that asset in previous tax computations. To make long term investment like purchasing land, buildings, machinery a firm have to earn an income greater than the fund committed. In order to handle these decisions, firms have to make an assessment of the size of the out flow and the inflows of the funds. One of the most important steps in the capital budgeting cycle is working out if the benefits of investing large capital sums outweigh the cost of these investments. Business organization can used two ways. ) traditional methods and 2) discounted cash flow techniques.