Budgeting and planning are gut-wrenching processes. A business leader might believe he can see the future, but the ulcer-inducing question is how does he clarify that vision to the degree necessary to take action? In good times or in times of market uncertainty, leaders require tools to help them decide what company assets should be committed to what course of action. The net present value and payback methods are two effective quantitative approaches when a business leader needs to gather intelligence, conduct analysis, debate decision implications, and make good capital investment decisions.
The capital budgeting process requires you to consider each potential project in both financial and investment terms. From an investment perspective, a project might grant a company access to new markets, established facilities in particular locations, and new brands to complement the company's existing product line. From a financial perspective, a project's cost must be offset by the sales and profits the project will generate within a specific timeframe. Before a business leader "bets the farm" on particular investment opportunities, he relies on capital-budgeting decision tools to consider the cash inflows and outflows of each capital investment opportunity to identify those that are most desirable in terms of the project's contribution to the accomplishment of a company's short- and long-term financial objectives.
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Net Present Value Method
The net present value method, called NPV, is one capital budgeting decision tool that uses discounted cash flow analysis to evaluate a project's net present value, which is equivalent to the financial benefit of pursuing a particular project. You determine a project's net present value by subtracting the project's cost from the cash the project will generate, which is stated as a discounted cash flow. You discount the project's future cash flow to reflect the risk associated with the anticipated cash flow, which decreases the current value of that cash flow. By discounting the project's cash flow, you can be more confident in the benefit your company will receive from the project. If using the NPV method to evaluate multiple projects, you first select projects with a positive net present value, and then, from this group, you select the project with the greatest NPV.
Straightforward in its application, the payback method is also used to evaluate capital investment projects. With this method, you first determine the time required for your company to recoup its investment in individual capital projects -- the payback periods -- and then select the project with the shortest payback period. To determine the payback period, you divide a project's total cost by the annual cash flow that you expect the project to generate. For example, if a project's purchase price is $210,000 and you expect the project to generate a cash flow of $30,000 per year, the project's payback period is seven years. When using the payback method to evaluate multiple projects, you select the projects that will "pay back" investment costs within a predetermined budget period. To select one project to budget, you then select the project with the shortest payback period from all acceptable options.
NPV Versus Payback Period
The net present value method evaluates a capital project in terms of its financial return over a specific time period, whereas the payback method is concerned with the time that will elapse before a project repays the company's initial investment. Unlike the NPV method, the payback method fails to account for the time value of money or project risk, but rather assumes all financial aspects of a project will progress as planned. In addition, the payback method fails to consider cash flow after the payback period. The NPV and payback methods evaluate a project in financial rather than investment terms, which precludes consideration of project benefits such as access to new markets or the acquisition of existing facilities. For these reasons, it may be appropriate to evaluate projects using more than one capital-investment evaluation tool.