Question

Assume you are the Director of Financial Planning and Analysis for your company. Make a recommendation to the CFO (me!) on how your company should approach capital budgeting and selection of projects for investment. Your recommendation can include discussion of any or all of the key topics studied in Chapters 10-14:

a) Preferred methodologies/tools (NPV, IRR, Payback)

b) Base Case, Scenario, & Simulation analyses

c) Real Options analysis

d) Impacts of Capital Structure and Leverage

What you choose to base your recommendation upon is less important than the articulation of the conceptual framework and the accurate application of that concept. Given this is a one-page recommendation, clearly you will not be able to incorporate all of the concepts above so pick one or two and demonstrate your comprehension of how it should be applied in financial analysis and capital budgeting.

Answer 1

Payback period is the time required to recover the initial cost of an investment. It is the number of years it would take to get back the initial investment made for a project. Therefore, as a technique of capital budgeting, the payback period will be used to compare projects and derive the number of years it takes to get back the initial investment. The project with the least number of years usually is selected.

For Example: XYZ ltd has two project options. The initial investment in both the projects is Rs. 10,00,000.

Project A has even inflow of Rs. 1,00,000 every year.

Project B has uneven cash flows as follows:

Rs. 2,00,000 in Year 1,

3,00,000 in Year 2

4,00,000 in Year 3

1,00,000 in Year 4

Formula

Total outflows /Inflow every year

Or

Initial Investment/Net annual cash inflows

By applying the payback period method to both the projects.

Project A

If we use the formula, Initial investment / Net annual cash inflows then:

10,00,000/ 1,00,000 = 10 years

Project B

Total inflows = 10,00,000 (2,00,000+ 3,00,000+ 4,00,000+ 1,00,000)

Total outflows = 10,00,000

Project B takes 4 years to get back the initial investment.

Now, let us modify the cash flows of project B and see how to get the payback period:

Say, cash inflows are –

Year 1 – Rs. 2,00,000

Year 2 – Rs. 3,00,000

Year 3 – Rs. 7,00,000

Year 4 – Rs. 1,50,000

The payback period can be calculated as follows:

Year	Total flow ( in Lakhs)	Cumulative flow
0	(10)	(10)
1	2	(8)
2	3	(5)
3	7	2
4	1.5	3.5

Step 1: We must pick the year in which the outflows have become positive. In other words, the year with the last negative outflow has to be selected. So, in this case, it will be year two.

Step 2: Divide the total cumulative flow in the year in which the cash flows became positive by the total flow of the consecutive year.

So that is: 5/7 = 0.71

Step 3: Step 1 + Step 2 = The payback period is 2.71 years.

Therefore, between Project A and B, solely on the payback method, Project B (in both the examples) will be selected