The payback period is a financial method which is used by many businesses and organizations to determine the period of time which the business requires to return on an investment so that they can be able to repay the amount of initial investment by the business.
It measures the duration which something takes to repay itself and therefore, shorter payback periods are more preferred than long periods of pay back. It is a widely used method due to its simplicity in use and its also very easy to understand. For example, if a business has invested 1000 dollars which has a rate of return of 500 dollars a year, the pay back period will be two years.
However, there are various limitations which accompany pay back period, one is that the method does not account for the time value of money and so as to eliminate this limitation, Apple computer should put into consideration the net present value of its investment, its internal rate of return as well as its use of discounted payback method. The method does not also account for the risks, financing and opportunity cost, it also ignores the benefits which a business gets after the payback period and as a result, a company may rank an investment which returns one million dollars after a two year period lower than one which does not return anything after one year (Van Horne &Wachowicz, 2004).Pay back period can be used in capital budgeting analysis because it is simple to understand and use and it is also able to have risks effectively. The method emphasizes more on a quick return on the investments so that the money can be reinvested or used in other areas of the business. 2. There are various types of cash flows which can be used in capital budgeting analysis; one is the incremental cash flow which is the additional operating cash flow an organization receives as a result of taking a new investment.
If there is a positive incremental cash flow, the company’s cash flow is likely to increase if it undertakes the investment and should therefore engage in it (Van Horne ; Wachowicz, 2004). However, it should look at the initial outlay, the terminal value or costs, cash flow from the investment and the time of the investment. The second cash flow that can be used is the free cash flow which shows the cash which the company has the ability to generate after it has laid the amount required in maintaining and expanding its asset base. It allows the company to undertake opportunities which enhance the value of shareholders and also to quantify the acquisition opportunities value. Another cash flow is the discounted cash flow method which assumes that the initial outlay of the company is known with certainty although many if the initial outlays have some level of uncertainty especially if dealing with new facility construction.
3. Internal rate of return can be used by the apple computer, Inc because it is more simpler to use and it simplifies the investments to be taken into a single number which the management of the company can be able to use in determining the viability of the investment.Net profit value is used to analyze the profitability of an investment in capital budgeting and it is very sensitive to the reliability of future cash flows which an investment is likely to give.
It compares the current dollar value to the future value while looking at inflation and returns and if NPV is positive, the investment should be adapted. Internal rate of return is used to decide on whether to invest or not and looks at the efficiency of investment, If IRR is greater than the rate of return of alternative investments, the investment is said to be good. Contrary, the Net profit value of a business shows the value or the magnitude of the investment to be undertaken.
However, both methods are used by businesses in evaluating opportunities available for investment.ReferencesVan Horne, J. C. ; Wachowicz, J. M., (2004), Fundamentals of financial management, Prentice Hall, ISBN: 0273685988.;