Why might it be rational for a small firm that does …



Why might it be rational for a small firm that does not have access to the capital markets to use the payback method rather than the NPV method? Please describe the key pluses and minuses of the main capital budgeting tools of analysis.

In deciding whether or not to accept an investment opportunity, firms resort to one (or more) capital budgeting tools to aid in the decision-making process. Those tools include:1) Payback Period Analysis (The number of years or periods required to recover an investment), 2) Net Present Value Analysis: the sum of the present values of all future cash flows less the initial investment, 3) Profitability Index: the ratio of the present value of future cash flows to the initial outlay (also known as the Cost-benefit Analysis), 4) Internal Rate of Return Method: the discount rate that equates the present value of an investment’s free cash flow to its initial outlay.

Although the Payback Period Analysis suffer the following deficiencies,

a) does not take all cash flows into account; only cash flows required to recoup the initial investment are taken into consideration, and

b) ignores the time value of money;

the payback period has some positive features such as a) it deals with cash flows rather than accounting profits and therefore only cash based funds are taken into consideration, and b) it is easy to calculate, and c) most importantly it makes more sense for a capital-constrained firms. Such firms which are mostly small ones might not have access to capital markets, hence it is often hard for them to raise capital, but since the main function of the financial manager is increasing the firm’s value, he should constantly undertake new investments. To be able to initially fund such investments with no access to the capital market, the financial manager have to carefully consider the timing of the cash flows since the firm might not be able to undertake new investment opportunities unless the old ones are recovered first.

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