Sorry to say but some finance professionals speak an ambiguous language. If you ask them whether this project is feasible or not, they will tell you that they will have to use capital budgeting techniques. Moreover, if you ask what capital budgeting is, they will tell you it is the process used to determine whether the long term investment is worth the funding of cash through your company’s capitalization structure. Difficult to understand – right.
You might have seen entrepreneurs who make decisions on the toe. You tell them about the investment and the cash generated by it per year, the life of the project. They will quickly tell you whether it is an exciting project or not and whether they want to investigate this project further or not.
Usually, the entrepreneurs use payback period estimates to shortlist the projects. The calculation is quite easy, and it does not require worksheets, financial calculators or anything like that. That’s why we say it back of the envelope calculation. So let us use an example. Somebody has contacted you that there is a long term project that requires an investment of $100,000 and its yearly return is $20,000. The project will last for ten years.
Let us do a back of the envelope calculation. If you invest 100k and get 20k per annum, you will get your money back in 5 years. The thumb rule is that lower the payback period, the higher are chances that the investors will further investigate the project.
The payback period is the period required for the amount invested in a project to be repaid by the net cash outflow generated by the project. It may be one of the simplest ways to evaluate the risk associated with a project. It is usually expressed in years and a fraction of years. Since it is a back of the envelope calculation, the time value money is not taken into account. Shorter payback periods are preferable to more extended payback periods. Payback period is popular due to its ease of use despite the various limitations.
The entrepreneurs keep a benchmark with them for the payback period, say three years. So in case, the project payback period is less than three years, they will ask their financial team to further investigate the project by developing future cash flows and looking at the riskiness of the project. The analysis is done by creating a complex financial model and then applying complex appraisal techniques such as net present value and internal rate of returns, discounted cash flows, etc. Once their internal team develops their calculations, the entrepreneurs based on their judgment further negotiate the price and timing of investment of the project. In case the cost is lower then the return from the projects will be higher also if the investment is phased over time, the entrepreneurs are expected to get higher yields.