Advantages and Disadvantages of Payback - Assignment Example

Fma Contents Answer 3 Advantages of payback 3 Disadvantages of payback 3 Advantages of Net present values 3 Disadvantages of Net present values 4 Answer 2 4 Answer 3 5 Differences between three 5 Advantages and disadvantages of these three 6 References 6 Answer 1 Advantages of payback The payback method is famous with business analysts for different reasons. It is a very simple method. It is a very easy concept to understand. Employees of different organization can easily understand the method. It is very important for each and every organization to understand their returns out of their investments. Every organization wants to get quickest possible returns out of their investments. In this case pay back method plays very significant role for the management. It has great advantages in terms measuring different investment risks. This method is very suitable for smaller projects. This method reveals different important information to the management. It is not very good idea to spend lots of money and time for conducting very sophisticated researches for smaller projects. In this situation this method is very helpful. Disadvantages of payback This method doesn’t consider time value of money. The cash inflows from a project may be uncertain, as maximum returns are dependent on future. One project may have a suitable rate of return but still may not meet the companys needed minimum payback period. The payback method does not take cash inflows from a project that may take place after the preliminary investment has been gained. Payback method is not suitable for big projects. Big projects have different complexities which cannot be analysed with the help of payback period. Payback period can be a reason for attractive project loss. This technique does not take care of original useful lives of different assets. Payback period gives high importance on liquidity and overlooks profitability. Advantages of Net present values Net present values give importance to time value of money. Here in this method both before and after cash flows of a project are taken in to the account. This is a great advantage of this method. Profitability and all risks related with the project are given significant importance. It has great contributions in terms of maximizing firm’s value. It is very important for financial managers to analyse different capital projects. This method helps financial managers to compare different projects. With the help of this method financial managers can compare more than one project options and can chose the suitable one. This method gives a clear picture to the managers about the possibilities of different future cash flows in present only. With the help of this method a direct measure is possible in terms currency contribution to share holders. Disadvantages of Net present values It is a very complex method and is very difficult to use. It needs lots of trainings for employees to calculate this method. Appropriate discount rate is very complex and difficult to calculate. Every project is having different life time. So, in case of unequal project lifetime this method gives faulty decisions. Sizes of the projects are not taken into the consideration in this method. This method is based on discount rates and future cash flows. All these are very difficult to calculate. Forecasting errors with the help of this method is also a significant disadvantage. Opportunity cost is also a great disadvantage related with this method (Ehsan, 2006). Answer 2 It is a calculation about firms cost of capital where each type of capital is proportionately weighted. Different capital sources like common stocks, bonds, preferred stocks and other long-term debts are considered in a WACC calculation. The capital investment of an organization is made up of two parts, those are debt and equity. All lenders and equity holders anticipate certain returns on their investments or capital they have given. The cost of capital is the anticipated return to shareholders and to different debt holders. WACC states that the returns of both stakeholders and equity owners. In other words, WACC signifies the investors opportunity cost for taking the risk of keeping money into an organization (Sudhindra, 2008). The weighted average cost of capital is the original cost that an organization pays for borrowing money. It is weighted for the degree to which different sum of money are taken at various rates. The consideration of the WACC as the discount rate has very good reason. The usage of the weighted average cost of capital as a discount rate is the reason because costs of financing are never taken as cash flows when a project being analysed. When scale of a project is not increasing, different financial managers tend to conduct ad hoc changes to the WACC in order to set the proper discount rate. Different investors use WACC as a method of their investment decisions. The WACC indicates the minimum possible rate of return at which an organization generates value for its different investors. An organization’s WACC is the total return on the firm as a whole. It is often being used internally by company’s managers to measure the economic possibilities of business expansion related opportunities or mergers. It is an appropriate discount rate to use for different cash flows and risks are similar with firm’s overall risks. WACC is generally used as the discount rate applicable to future cash flows for calculating net present value of a business. WACC is a great technique for investors to check different realities related with business. On the basis of those realities investors invest into any business. WACC is the discounted rate of return that is used in cash flows related with different capital budgeting techniques such as NPV, discounted payback period and MIRR. WACC gives hurdle rate that can be compared with IRR to analyse different logical reasons for any investment. It is also a very strong argument for using weighted average costs of capital as discount rate. If internal rate of return is higher than WACC then that project is profitable. On the other hand if internal rate of return is lower than WACC the project would have negative net present value means the project is not suitable. Here WACC is a bench mark for an investment (Pandey, 2009). All the above factors point towards different arguments related with weighted average costs of capital as discount rate in case of investment appraisal are very true, suitable and logical. Answer 3 Three main sources of long term finances for a large PLC are Shares, Bank Loans and Venture Capital Institutions. There are lots of differences between these three long term sources of finance. Differences are discussed below. Differences between three Shares are parts ownership of an organization. Venture capitalists are collections of individuals or organizations specifically set up to invest in different companies. Different banks often lend money to business organizations. In case of shares generally people invest money to an organization. In case of venture capital it is generally a group of wealthy people or consortiums of different organizations investing money in a company. In case of bank loans different banks provide money in exchange of certain interest rates. Shares are very common source of long term finance. Bank loans are also very common source of long term finance. But venture capitals are not very common source of long term finance as shares and bank loans. Shares are more secure ways of long term finance. Bank loans and venture capital are not that much secure ways of long term finance. In case of shares, share holders do not need any managerial or technical expertise. But in case of venture capital managers need technical expertise (Crosson and Needles, 2010). In case of bank loans firms repayment abilities are being considered. But in case of shares firm’s profitability is being considered. For venture capital firm’s potentials are being analyzed. In case of bank loan, bank fixes the rate of interest and time period for loan repayment. In case of shares and venture capital no such things are there. Shareholders of organizations get dividend from shares but in case of bank loans bank gets interest against invested money and venture capitalist gets some portion of ownership or some portion of profitability. Advantages and disadvantages of these three Share capital has no fixed maturity and there is no obligation for redeem. Paying dividend is not compulsory for large PLC. It has very high leverage capacity. Dividends are not accounted for tax. It is a very important advantage as far as stake holders for big PLC’s are concerned. Controls over the organization get reduced. Expected rate of returns from equity holders are more than debt holders of the company. It causes high costs for the company. With the help of bank loan big PLC’s can easily plan their businesses for long term. Interest rate is fixed. Large PLC’s can get lower interest rates for their reliabilities (Chandra and Prasanna. 2011). Interests are serious disadvantages of bank loans. It is very difficult to predict uncertain business scenario. Big PLC’s must keep some collateral against their bank loans. Venture capital provides required financial helps to the PLC. It also provides expert control from investors. For this source of funding PLC don’t need too much history and popularity in the market. Decision making is a serious disadvantage for PLC in case of venture capital funding. It is a very difficult process for PLC because lots of legalities are related with the process. References Chandra, P. and Prasanna. 2011. Financial Management. New Delhi:Tata McGraw-Hill Education. Crosson, S, V. and Needles, B. E. 2010. Managerial Accounting. London: Cengage Learning. Ehsan, N. 2006. Finance. New York: Barrons Educational Series. Pandey, I.M. 2009. Financial Management. New Delhi: Vikas Publishing House Pvt Ltd. Sudhindra, B. 2008. Financial Management. New Delhi: Excel Books India. Read More