Answer to Question #218526 in Finance for Roy

Question

QUESTION # 2

 

1.    Discuss the commonly used procedures for ranking investment proposals. what are the advantages and disadvantages of these techniques? (Use examples where appropriate)

Answer 1

1. Payback Period Method

It is expressed in years and takes cash inflows from capital investment project for it to equal the cash from outflows. This method acknowledges original capital investment recovery The the project’s cash outflows will be equal to cash inflows at the payback period from a project. In this method, the recovery time is specified by cash inflow accumulation inflows yearly until the original investment amount equals cash inflows. The time length this process takes gives the project ‘pay-back period’.

Advantages

-It is easy to understand, simple to apply and has particular importance to the business that lack the relevant skills appropriate for sophisticated techniques.

-This technique is suited in cases where future is uncertain. It can be used as an indicator because the less the payback period the smaller the risk.

-The company is compelled to invest in short payback period projects in case of capital rationing.

-This methods indicates specification of when the funds of prospective investors are likely to be repaid.

Disadvantages

-The method does not indicate if the investment should be rejected or accepted unless there is comparison between an arbitrary managerial target and the payback period.

-It ignores generation of cash beyond the period of payback and this can be seen more as a liquidity measure than profitability.

-It does not consider returns timing and capital cost.