I’m sorry, but some financial professionals are speaking ambiguously. If you ask them if this project is feasible, they will tell you that they will have to use capital budgeting methods. Moreover, if you ask what capital budgeting is, you will be told that it is the process used to determine whether a long-term investment is worth financing cash through your company’s capitalization structure. It’s hard to understand – it’s true.
You may have seen entrepreneurs who make decisions directly. You tell them about the investment and the money they get per year, the life of the project. They will quickly tell you whether the project is exciting or not, and whether or not they want to explore the project further.
Entrepreneurs usually use payback estimates to shortlist projects. The calculation is quite simple and does not require worksheets, financial calculators or anything like that. That’s why we say it’s an out-of-the-envelope calculation. So let’s use an example. Someone contacted you that there is a long-term project that requires an investment of $100,000 and an annual profit of $20,000. The project will last ten years.
Let’s do a back-of-the-envelope calculation. If you invest 100k and get 20k a year, you will get your money back in 5 years. The main rule is that the longer the payback period, the higher the chances that investors will study the project further.
The payback period is the period required for the amount invested in the project to pay for itself through the net cash outflows generated by the project. This can be one of the easiest ways to assess the risk associated with a project. It is usually expressed in years and fractions of years. Since this is the reverse of the envelope calculation, the time value of money is not taken into account. Shorter payback periods are preferable to longer payback periods. The payback period is popular due to its ease of use, despite various limitations.
Entrepreneurs keep a benchmark for the payback period, say, three years. Therefore, in the event that the payback period of the project is less than three years, they will ask their finance team to do further research on the project by working out the future cash flows and considering the riskiness of the project. The analysis is done by creating a sophisticated financial model and applying sophisticated valuation techniques such as net present value and internal rate of return, discounted cash flows, etc. cost and terms of investment of the project. If the cost is lower, then the returns from the projects will be higher, and if the investments are phased in time, entrepreneurs are expected to receive higher incomes.