Question

1. Payback period is one of the nondiscounting models used in capital investment decisions. What are some of the pros and cons associated with this model?

2. What is a capital investment and why do companies need to evaluate whether to make the investment or not?

3. Why do come companies prefer to use discounting in their capital investment decisions? What is a risk associated with this discounting model?

Answer 1

Answer 1 :

Payback period (PBP) is the time (number of years) it takes for the cash flows of incomes from a particular project to cover the initial investment. Pros and cons ( advantages & disadvantage ) of PBP as follows :

Advantages	Disadvantage
This model is easy and simple	It ignore anual cash flow
It stresses the liquidity objective	It consider only the period of pay back
It is useful in case of uncertainity	It over looks capital cost
It give quick solution	It is delicate and rigid
	This method over emphasises the importants of liquidity as a goal of capital expenditure decisions

Answer 2 :

Capital investment is a sum of money provided to a company to further its business objectives. The term also can refer to a company's acquisition of long-term assets such as real estate, manufacturing plants, and machinery.An established company might make a capital investment using its own cash reserves, or seek a loan from a bank. If it is a public company, it might issue a bond in order to finance capital investment.

The capital is to be used to further develop and market its products. When a new company goes public, it is acquiring capital investment on a large scale from many investors.Capital investments generally are made to increase operational capacity, capture a larger share of the market, and generate more revenue. The company may make a capital investment in the form of an equity stake in another company's complementary operations for the same purposes.

Answer 3 :

Discounting is the process of determining the present value of a payment or a stream of payments that is to be received in the future.From a business perspective, an asset has no value unless it can produce cash flows in the future. Stocks pay dividends. Bonds pay interest, and projects provide investors with incremental future cash flows. The value of those future cash flows in today's terms is calculated by applying a discount factor to future cash flows.

In general, a higher the discount means that there is a greater the level of risk associated with an investment and its future cash flows. Discounting is the primary factor used in pricing a stream of tomorrow's cash flows. For example, the cash flows of company earnings are discounted back at the cost of capital in the discounted cash flows model. In other words, future cash flows are discounted back at a rate equal to the cost of obtaining the funds required to finance the cash flows. A higher interest rate paid on debt also equates with a higher level of risk, which generates a higher discount and lowers the present value of the bond. Indeed, junk bonds are sold at a deep discount. Likewise, a higher the level of risk associated with a particular stock, represented as beta in the capital asset pricing model, means a higher discount, which lowers the present value of the stock.