There are several investments that a small business can make. It is a financial manager's job to help the management team assess the investments, rank them and suggest options. This process is referred to as capital budgeting.
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A few investments, however, defy financial analysis. An example of this might be seen in charitable donations which deliver intangible benefits that financial mangers alone can't evaluate.
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It might be argued that investment decisions fall under one of three basic decision categories:
-Accept or reject a single investment offer.
-Choose one competing investment over another.
-Capital Rationing - For this particular category, the limited investment pool is active deciding which projects among several should really be chosen.
While every corporation utilizes its own criteria to ration its limited resources, the important tools are:
-Payback period
-Net present value
With the payback period strategy, several businesses think that the best way to judge investments are to calculate the quantity of time it takes to recover their investments.
Analysts can simply calculate paybacks and make simple acceptance or reduction decisions depending on a necessary payback period. Those projects that come close to the mark are accepted, those falling short are rejected.
For instance, the managers of a small business may think that all energy and labor saving devices ought to possess a three-year payback and that all new machinery must have an eight-year payback.
Furthermore, research projects really should pay back in ten years. Those requirements are based on management's judgments, knowledge, and level of risk.
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By accepting opportunities with longer paybacks, management accepts more risk. The further out an investment's payback, the more unclear and risky it really is.
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Payback criteria is desirable simply because they are simple to use, calculate and understand; however they ignore the timing of cash flows and accordingly the time value of money. Projects with very different cash flows can have exactly the same payback period.
Another disadvantage of working with payback is that it ignores the cash flows received right after the payback.
Net present value methods
The same method used for pricing the cash flows of bonds and stocks is also used to value projects. It is the most accurate and most accurate approach.
The further in the future a dollar is received, the higher the uncertainty that it'll be received, referred to as risk, and the higher the loss of opportunity to use those funds, known as opportunity cost.
Accordingly, cash flows obtained in the future will be discounted more steeply according to the riskiness of the project.
The way a small business wishes to fund itself are financing decisions independent of investment choices.
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In summary, whereas most companies may continue to use the payback system on account of the aforementioned reasons, it is well worth noting that other alternatives are there.
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