Calculation of NPV and Payback Period in Business Decision Making

This study highlights the calculation of NPV and payback period in business decision making, analyzing the benefits and limitations of these methods. It also explores the impact of financial and non-financial factors on stakeholders and the decision-making process.

BUSINESS DECISION
MAKING

Contents
INTRODUCTION......................................................................................................................3
MAIN BODY.............................................................................................................................3
Calculation of NPV in project A and B.................................................................................3
Calculation of the payback period..........................................................................................5
Financial and non-financial factors and its impact on stakeholders and decision making
procedure................................................................................................................................6
CONCLUSION..........................................................................................................................7
REFERENCES...........................................................................................................................8

INTRODUCTION
A decision making process is referred to as an effective course of action which helps
in achieving the organizational goals and objectives. This study is useful to highlight on
calculating NPV and Payback period. It is very useful in analysing the benefits and
limitations of the payback period and NPV. It will also demonstrate financial and non-
financial factors and its impact on stakeholders and decision making procedure.
MAIN BODY
Calculation of NPV in project A and B.
Project A
Computation of NPV
Year Cash inflows
PV factor
@ 11%
Discounted
cash
inflows
1 28000 0.901 25225.2
2 32000 0.812 25972
3 35000 0.731 25592
4 55000 0.659 36230
5 78000 0.593 46289
Total discounted cash
inflow 159308
Initial investment 100000
NPV (Total
discounted cash
inflows - initial
investment) 59308
Project B
Computation of NPV
Year
Cash
inflows
PV factor
@ 11%
Discounted
cash
inflows

1 31000 0.901 27927.9
2 38000 0.812 30842
3 43000 0.731 31441
4 64000 0.659 42159
5 89000 0.593 52817
Total discounted cash
inflow 185187
Initial investment 120000
NPV (Total discounted
cash inflows - initial
investment) 65187
Interpretation: The net present value in turn tends to largely apply to the various degree of
cash flows which in turn tends to occur at varied set of time (Leyman and Vanhoucke, 2016).
Net Present value is referred to as the difference between the current value of the cash
inflows and the present value of cash out flows over a significant duration of time. The
positive net present value tends to imply that, the investment within the specific project is
worthwhile. It states that, the projected earnings which in turn has been made from the
project is more than anticipated cost. The project which has positive net present value is
considered to be highly profitable. However, the positive NPV tends to state that, the cash in-
flows are equal to the cash out- flows (Regan, and et.al., 2015). Moreover, the negative net
present value of the specific project will in turn tends to state that, projected earnings which
in turn has been made from the project is lower than anticipated cost. Negative NPV of the
specific project results in loss for the business. The NPV of the initial Project A is 59308 and
the NPV of the Project B is 65187. However, the company will select project B i.e.,
Laundrette project because the NPV is greater and will result in high degree of profitability
for the company.
The key benefits associated with the net present value are:
 It tends to accept conventional pattern of cash flow and also considered all the cash
flows of period.
 NPV is an effective measure associated with profitability.
 It tends to consider the time value of money (Rychłowska-Musiał, 2017).

The key disadvantage associated with the net present value are:
 Ignoring of the sunk cost.
 There might be a significant difference in the size of project.
 Optimistic projections and assumptions.
Calculation of the payback period
Project A
Computation of Payback period
Year
Total cash
flow
Cumulative cash
flow
1 28000 28000
2 32000 60000
3 35000 95000
4 55000 150000
5 78000 228000
Payback
period
3 + 5000 /55000
3 + 0.1
= 3.1 years
Project B
Computation of Payback period
Year
Total cash
flow
Cumulative cash
flow
1 31000 31000
2 38000 69000
3 43000 112000
4 64000 176000
5 89000 265000
Payback
period
3+ 8000/43000
= 3.2years

Interpretation: Payback period is an effective capital budgeting tool which is very useful in
recouping the funds which has been invested within particular project. (Gorshkov and et.al.,
2018) Payback period is considered to be as the amount of time a company takes in order to
recover the cost associated with the project investment. The shortest payback period in turn is
referred to as one of the most prominent and acceptable project. It is an effective concept
which helps the management of the organization decide between various investment and
projects. One of the key reason shortest period is selected to recoup the money invested in the
earliest time possible (Orioli and Di Gangi, 2015). The Project A payback period is estimated
to be 3.1 years and the payback period for Project B is estimated to be 3.2 years. However,
the company will select Project A because it can recoup the amount of investment in shorter
time period when compared with the Project B.
The key benefits associated with the Payback period are:
 It takes into consideration discount rates in order to calculate the appropriate payback
period.
 It is a simple method and easy to understand.
 It is useful in determining the actual risk which has been involved within the project
(Gorshkov, Murgul, and Oliynyk, 2016).
The key disadvantage associated with the Payback period are:
 It tends to ignore the time value of money.
 It does not tend to cover all cash flows (Advantages & Disadvantages of Payback
Capital Budgeting Method, 2020).
 It tends to ignore the profitability of the project.
Financial and non-financial factors and its impact on stakeholders and decision making
procedure.
Financial factors such as income, gross profit, cost of goods, etc. are the key factors
which largely influence the decision making of the stakeholders.
Non- financial factors such as legislations, good practice, industry standards, morale
and satisfaction level of employees, etc. which largely influence the decision making of the
stakeholders (Almaktar, Abdul Rahman, and Hassan, 2016).
Financial and non-financial factors also influence the decision making process which
in turn is useful to attain the goals and objectives of the company (Leyman and Vanhoucke,

2016). It is useful in building better set of relationship and investing in the right projects
which are profitable.
CONCLUSION
This study summarizes that, Positive NPV tends to result in high degree of
profitability for the company. Moreover, shortest period is selected to recoup the money
invested in the earliest time possible. Financial and non-financial factors also influence
stakeholders and decision making process which in turn is useful to attain the goals and
objectives of the company.

REFERENCES
Books and Journals
Almaktar, M., Abdul Rahman, H. and Hassan, M.Y., 2016. Economic Analysis Using Net
Present Value and Payback Period: Case Study of a 9kWp Grid-Connected PV System at
UTM, Johor Bahru Campus. In Applied Mechanics and Materials (Vol. 818, pp. 119-123).
Trans Tech Publications Ltd.
Gorshkov, A., Murgul, V. and Oliynyk, O., 2016. Forecasted Payback Period in the Case of
Energy-Efficient Activities. In MATEC Web of Conferences (Vol. 53, p. 01045). EDP
Sciences.
Gorshkov, A.S and et.al., 2018. Payback period of investments in energy saving. Magazine of
Civil Engineering, (2).
Leyman, P. and Vanhoucke, M., 2016. Payment models and net present value optimization
for resource-constrained project scheduling. Computers & Industrial Engineering, 91,
pp.139-153.
Orioli, A. and Di Gangi, A., 2015. The recent change in the Italian policies for photovoltaics:
Effects on the payback period and levelized cost of electricity of grid-connected photovoltaic
systems installed in urban contexts. Energy, 93, pp.1989-2005.
Regan, C.M and et.al., 2015. Real options analysis for land use management: methods,
application, and implications for policy. Journal of environmental management, 161, pp.144-
152.
Rychłowska-Musiał, E., 2017. Value Creation in a Firm Through Coopetition: Real Options
Games Approach. In Contemporary Trends and Challenges in Finance (pp. 285-295).
Springer, Cham.
Online
Advantages & Disadvantages of Payback Capital Budgeting Method. 2020. [ONLINE].
Available through< https://smallbusiness.chron.com/advantages-disadvantages-payback-
capital-budgeting-method-14206.html>