Don Hofstrand Capital Budgeting Simulation

The payback period looks at a project only until the costs have been recovered. This analysis tool is often ignored because it does not take into consideration the time value of money. The time value of money limitation of the payback period can be modified by using the discounted cash flows of a project for the analysis of when the outflows will be recovered.

This mini-case provides a review of the methodology and rationale associated with the various capital budgeting evaluation methods such as payback period, discounted payback period, NPV, IRR, MIRR,

There are different types of budgeting that businesses typically use and those include Operating budgets, Capital Budgets and there are many subtypes that exist because a budget can also be created for special events, the recruitment and retention of new staff, and to manage the advertising expenses and return on investments for a business (Demand Media, 1999-2012). According to Demand Media (1999-2012), "An operating budget outlines the total operating expenses and income for the organization, typically for the period of a fiscal year. Capital budgets evaluate the investments and assets of the business, and a cash budget shows the predicted cash flow in and out of the business over a period of time” (para.2 ). According to the Cost-Benefit Analysis (2012), “Capital budgeting has at its core the tool of cost-benefit analysis; it merely extends the basic form into a multi-period analysis, with consideration of the time value of money. In this context, a new product, venture, or investment is evaluated on a start-to-finish basis, with care taken to capture all the impacts on the company, both cost and benefits. When these inputs and outputs are quantified by year, they can then be discounted to present value to determine the net present value of the opportunity at the time of the decision” ("Cost-Benefit Analysis," 2012).

EEC calculated the amount of time involved the anticipation of its cost ($3 million). The timeline in recovering their cost of investment ($2 million) initially for the foundation of this investment any profit made in the future of this investment will be justified as a profit for the company. If EEC can anticipate a fast return on its investment it is a profitable wise decision in making the investment financial, it is considered to be an easier way of formulating investments financially. On the basis of one year all cash flows is added together equal to the sum of $2 million originally invested, then it is divided by the annual cash flow of $500,000. The calculation of the payback period would equal four years. After this time frame any financial proceeds will be considered profitable for the company. I conclude that the timeframe is adequate in comparison of the investment in this worthwhile investment financial venture for the company.

Capital planning and budgeting is a very vital piece in the Public Budgeting System process. It is an essential implement in the financial management practice and is effective in both public and private organizations. It is the method which consists of the determination and the evaluation of the investments and the possible expenses by an organization. As explicate by Lee, Johnson, & Joyce (2008), capital budgets help in determining how much of each form of investment is needed, and it supports an organization in assessing the available revenue which includes loans is required to finance those investments (p. 475). Capital budgeting is a central part of the universal

Capital Budgeting encourages managers to accurately manage and control their capital expenditure. By providing powerful reporting and analysis, managers can take control of their budgets.

In real live project with more cash flow after the pay back period would be more valuable than Project with no cash flow, yet its payback and discounted payback make it look worse. This is the reason, the shorter the payback period, other things held constant, the greater the project’s liquidity. Apart from this, since cash flows expected in the distant future are generally riskier than near-term cash flows, the payback is often used as an indicator of a project’s riskiness because the longer the payback period the higher is the risk associated with the project (Brigham, 2004) (Fabuzzi, 2003).

Capital budgeting decisions involve investments requiring large cash outlays at the beginning of the life of the project and commit the firm to a particular course of action over a relatively long period of time. As such, they are costly and difficult to reverse, both because of: (1) their large cost and (2) the fact that they involve fixed assets, which cannot be liquidated easily.

When making capital budgeting decisions, there are various techniques that can be utilised. Ross et al. (2008) describes that the predominant capital budgeting methods used as being the Net Present value (NPV) method, the Internal Rate of Return (IRR) method, the Payback method, and the Accounting Rate of Return (ARR) method. Conversely, Brealey, Myers and Allen (2011) proposes that the NPV and IRR methods are considered prestige compared to the ARR and the Payback Methods, as they take into account the time value of money. Thus, the following project evaluation will focus on using the NPV and IRR methods.

the amount of time required for an investment to generate cash flows sufficient to recover its initial cost

The formula for the payback method is simplistic: Divide the cash outlay (which is assumed to occur entirely at the beginning of the project) by the amount of net cash flow generated by the project per year (which is assumed to be the same in every year). ("Payback Period Formula - AccountingTools,"

The PAYBACK technique is based on cash flows and it measures the time which is required for a proposal’s initial cash outflow to equal its cash inflow generated by the investment, the solution is expressed in years and month or days.

This method is simply the number of years required to recoup the original investment cost of capital (Emory, 2007). This is a quick and easy method for giving investors a length of time that their investment would be paid for without regard to the time value of money. If the required return fits within the parameter of the payback period and other contributing risk factors are not enough of a deterrent then the investment may be worth looking at more closely.

a. Capital budgeting is the process of analyzing projects and determining which ones to accept and include in the capital budget.

***Tim must explain to the board that Payback Method does not consider the cost of the capital (debt/equity) that the project will undertake which is reflected in the cash flow. It only states the length of time the company will be tied up in the project. He should also emphasize that the PBP method ignores the time value of money as well as the cash flows occuring after the payback period.