Business Investment Decisions
There are many investments that a company can make. It is a financial manager’s job to help the management team evaluate the investments, rank them and suggest choices. This process is called capital budgeting. Some investments, however, defy financial analysis; an example of this may be seen in charitable donations, which provide intangible benefits that financial mangers alone cannot evaluate. It may be argued that investment decisions fall into one of three basic decision categories: Accept or reject a single investment proposal Choose one competing investment over another Capital rationing – with this particular category, the limited investment pool is active deciding which projects among many should be chosen. Whilst each corporation uses its own criteria to ration its limited resources, the major tools are: Payback period Net present value Payback period method – many companies believe that the best way to judge investments is to calculate the amount of time it takes to recover their investments.
Analysts can easily calculate paybacks and make simple acceptance or reduction decisions based on a necessary payback period. Those projects that come close to the mark are accepted, those falling short are rejected. For example, the managers of a small company may believe that all energy and labour saving devices should have a three-year payback and that all new machinery must have an eight-year payback. Additionally, research projects should pay back in ten years. Those requirements are based on management’s judgements, experience, and level of risk.
By accepting projects with longer paybacks, management accepts more risk. The further out an investment’s payback, the more uncertain and risky it is. Payback criteria are desirable because they are easy to use, calculate and understand; however they ignore the timing of cash flows and accordingly the time value of money. Projects with vastly different cash flows can have the same payback period. Another disadvantage of using payback is that it ignores the cash flows received after the payback. Net present value methods The same method used for valuing the cash flows of bonds and stocks is also used to value projects. It is the most accurate and most correct method. The further in the future a dollar is received the greater the uncertainty that it will be received, referred to as risk, and the greater the loss of opportunity to use those funds, referred to as opportunity cost. Accordingly cash flows received in the future will be discounted more steeply depending on the riskiness of the project. The way a business wishes to fund itself are financing decisions independent of investment decisions.
In my own experience, I have only ever used the payback method, along with my fellow business colleagues, perhaps because this has always been easier to understand and use and calculate. This served us well but caused frequent conflicts between operations, marketing and finance, for understandable reasons. In summary, whereas most companies may continue to use the payback method due to the aforementioned reasons, it is well worth noting that another option is there and, especially for the financial side of the business, gives a very interesting option.
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