Business Decision Making: Payback Period and NPV

Calculation of Payback Period

X Plc Is a Reputed Vehicle Parts Company, Trading In The Uk And Some Parts Of The Europe. Strategic Managers Of x Plc Are Looking To Invest In a New Business. They Have Called New Business Proposals And Finally, Chosen Two Projects In Managers’ Discretion To Make Final Decision. Initial Investment Required For Project a Is £20000 And For Project b Is £30000. The Rate Of Return Expected Is At 10%. The Net Cash Flows For Two Projects Can Be Summarized As Below:

You Are Required To Write An Essay On Business Decision Making, Covering The Payback Period And Npv, And Financial And Non-Financial Factors Used To Aid Decision Making.

X plc that is engaged in dealing with vehicle parts conduct its business in parts of Europe and UK. At present the management of the entity is looking for investing in the new business and selected 2 projects to continue with one among those. The task will evaluate 2 projects with various investment appraisal techniques such as payback period and net present value. Based on the outcomes the task will recommend the best one to be considered for investment (Brailsford, Churilov and Dangerfield 2014).

Payback period = 2+(ABS(2000)/12000) = 2.17 years

Calculation has been made as follows 

Payback period = 2+(ABS(5000)/17000) = 2.29 years

It is the time that is expected to be taken by the project to regain the amount of initial investment through generating the cash flows from the investment. Estimates for the cash flows are generally quite accurate for the near periods as compared to the cash flows for the distant future period on account of operational as well as economic uncertainties. Hence, projects with shorter payback period are generally preferred over the projects with longer payback period. Payback period can be used for identifying the inherent risk as the same considers initial inflows and disregard cash flows after the time where initial investment is regained (Gorshkov et al. 2014).

Advantages associated with this technique are (i) Simple method – this technique is simple as against the techniques used by number of entities that is not only biased but also difficult in computing. Conversely, payback period takes into account the number of years for regaining the initial investment which is easy as well simple in understanding (ii) offers quick analysis – it helps in determining the project that can generate faster returns with available resources. Managers of the organization use this technique for quick analysis in context of the projects with shorter payback period and small investments (Lin, Chang and Chung 2015).

Computation of NPV

 Disadvantages associated with this technique are (i) TVM (time value of money) – it disregards TVM that is the discounted cash flows are not considered which is considered as crucial while taking investment related decisions as money received today differs from the value of money if the same is received tomorrow (ii) Cash flow after payback period – Generally cash flow of any project with long-term can be irregular and may generate earning even after regaining the initial investment amount. However, under this technique projects with long payback period are generally overlooked (Gorshkov et al. 2018).

It represents changes in the net worth of any organization that will be resulted from accepting of any project over the lifetime of the same. It is equal to the present value of any project’ net cash flows including both inflows as well as outflows. This technique is considered as most reliable among all the techniques used for analysing investment appraisal as the same is dependent upon the technique of discounted cash flows. Project is accepted if the NPV of any project is positive and rejected if the same resulted into negative amount (Kovačić and Bogataj 2017).

Advantages associated with this technique are (i) TVM – major advantage of this technique is that it accounts for the basic idea that the money received today differs from the value of money if the same is received tomorrow. In each of the period under concern cash flows are discounted by other period of the capital cost (ii) generation of profit – this technique also represents whether the project will generate profit for the entity or not and if yes then how much in context of dollars (iii) capital cost – it accounts for the capital cost and inherent risk while making the estimations in context of future period.  Cash flows estimated for the future period is less certain as compared to near period and hence, the future cash flows have less impact on NPV as compared to near period cash flows (Leyman and Vanhoucke 2017) 

Disadvantages associated with this technique are (i) forecasting error – for forecasting the cash flows associated with the project through NPV the entity makes number of assumption through applying incomplete information. For instance, forecast for 2 years can be accurate however forecast for 10 years may not be accurate as the same involves guesswork (ii) it requires estimating the discount rate of the project that is the percentage used for converting the future cash flows into present value. Discount rate is dependent on the interest rate and project’s risk. Hence, small changes in the interest rate will change the NPV of the project and which in turn may make the decision vague (Žižlavský 2014).

Analysis

From the above it can be suggested that though the payback period for project A is lower as compared to project B, as the NPV is more for Project B, the same shall be chosen over project A. NPV has been taken as decisive factor as it is more reliable as compared to payback period techniques as the same ignores TVM.

Financial factors taken into account for making decisions involves – (i) return on investment as the same has direct impact on the business profitability (ii) opportunity cost as while making the choice for any one project opportunity for making another is lost (iii) impact on resources as while the business profit is computed from the probable decision overall impact on the sales, accounting, information technology, production and human resources are also taken into account (Tjader et al. 2014)   

Non-financial factors taken into account for making decisions involves – (i) achieving requirements associated with current as well as future legislation (ii) enhancing the morale of the employees that will make the recruitment as well as retaining the employees easier (iii) estimating and dealing with the future threats including providing protection to intellectual property against the potential competition (iv) developing business capabilities including business skills as well as experiencing in the new areas or enhancing the system of management (Carvalho, Meier and Wang 2016).

Managerial decision making is generally featured by incomplete information, time constraint and complexity and hence, there is rarely any single right answer. The managers shall weigh possible consequences for each of the decision and consider the fact that generally there are multiple shareholders with different preferences and conflicting needs (Brailsford, Churilov and Dangerfield 2014).

Conclusion

From above interpretation it is concluded that for X Ltd if the management chose project B over project A, it will be able to earn additional profit amounting to $(29,655.64 – 26,595.67) = $3,059.96. Additional profit will in turn enhance the net worth of the entity as well as wealth of the shareholders. Hence, it is recommended that X Plc shall invest in project B

References 

Brailsford, S., Churilov, L. and Dangerfield, B. eds., 2014. Discrete-event simulation and system dynamics for management decision making. Chichester: Wiley.

Carvalho, L.S., Meier, S. and Wang, S.W., 2016. Poverty and economic decision-making: Evidence from changes in financial resources at payday. American Economic Review, 106(2), pp.260-84. 

Gorshkov, A.S., Rymkevich, P.P., Nemova, D.V. and Vatin, N.I., 2014. Method of calculating the payback period of investment for renovation of building facades. Stroitel'stvo Unikal'nyh Zdanij i Sooruzenij, (2), p.82.

Gorshkov, A.S., Vatin, N.I., Rymkevich, P.P. and Kydrevich, O.O., 2018. Payback period of investments in energy saving. Magazine of Civil Engineering, 78(2).

Kovačić, D. and Bogataj, M., 2017. Net present value evaluation of energy production and consumption in repeated reverse logistics. Technological and economic development of economy, 23(6), pp.877-894.

Leyman, P. and Vanhoucke, M., 2017. Capital-and resource-constrained project scheduling with net present value optimization. European Journal of Operational Research, 256(3), pp.757-776.

Lin, W.M., Chang, K.C. and Chung, K.M., 2015. Payback period for residential solar water heaters in Taiwan. Renewable and Sustainable Energy Reviews, 41, pp.901-906.

Tjader, Y., May, J.H., Shang, J., Vargas, L.G. and Gao, N., 2014. Firm-level outsourcing decision making: A balanced scorecard-based analytic network process model. International Journal of Production Economics, 147, pp.614-623.

Žižlavský, O., 2014. Net present value approach: method for economic assessment of innovation projects. Procedia-Social and Behavioral Sciences, 156, pp.506-512.