Capital budgeting involves techniques that aid in decision making. Therefore, I will use the payback period technique to estimate the duration it will take to recover the initial capital outlay.
Capital budgeting introduction will help in making decisions about whether to invest in a new project or abandon a project which does not perform well (Damodaran, 1996).
The payback period will consider the entire cash flows, especially the estimated cash flows for the future years (Mahlia, Razak, & Nursahida, 2011). The company produces its gadgets in two phases. The first batch consists of 1000 units and the second batch comprises 1000 units. The estimated cash flows for the first ten years since establishment are as follows;
Year cash inflow Accumulated cash flows
- 1,000,000 1,000,000
- 1,650,000 2,650,000
- 1,800,000 4,450,000
- 1,700,000 6,150,000
- 1,600,000 7,750,000
- 1,450,000 9,200,000
- 1,600,000 10,800,000
- 1,700,000 12,500,000
- 2,000,000 14,500,000
- 2,500,000 17,000,000
The initial capital required was ten million dollars. The amount invested is expected to be recovered so that the business can be able to finance its activities from its own money. The non-discounted payback period will be computed based on the cash flows provided. To obtain the payback period I will apply the following formula;
From the calculations, it is evident that it will take six years and six months to recover the initial investment channeled towards the project. The business is expected to be a going concern meaning it will generate cash flows as long as it operates for the foreseeable future.
The payback period may consider discounted cash flows so as to make the decision in regards to the concept of time value of money.
References
Damodaran, A. (1996). Corporate finance. Wiley.
Mahlia, T. M. I., Razak, H. A., & Nursahida, M. A. (2011). Life cycle cost analysis and payback period of lighting retrofit at the University of Malaya. Renewable and Sustainable Energy Reviews, 15(2), 1125-1132.
