The Capital Budgeting Method Term Paper Example | Topics and Well Written Essays - 1500 words

The Capital Budgeting Method - Term Paper Example It should be noted that in the assessment of the profitability of an investment, it is also important to consider the timing of cash inflows. The rationale behind this is expressed in the concept of the time value of money which is widely recognized as one of the single most important concepts in financial analysis. This tells us that a dollar to be paid today has a higher value than any dollar to be paid tomorrow. Holding a dollar has an opportunity cost in terms of interest.   Thus, a dollar invested today can be turned into $1.10 next year when lent at 10% interest. In the same way, a dollar collected today will be used by a company to be invested in its profitable undertakings which can yield more dollars in the future. Thus, it can be deduced that investments which generate more cash earlier in their lives are more profitable. This might sound consistent with the payback period. However, it should be noted that NPV takes into account the total cash flow generated by the invest ment and does not stop when the total investment is recouped.          NPV, unlike the payback period, recognizes the importance of a company’s present return on investment. It should be noted that when the company calculates the return on investment using NPV, it measures the cash flow based on the cost of capital. The payback period, on the other hand, only looks at the earliest possible time the investment is recouped and not at the investments meeting the standard of the company.               A typical business organization extends credit to the customer for various reasons. It is often uncommon to find a company which collects the totality of payment for its products and services in cash.   It should be noted that extending credit exposes a business entity to risks of default. Unlike cash which ensures the full and ready payment of the company’s goods and services, credit only gives the customer an obligation. With credit, customers have the right to default for any reason. This leaves companies with receivables which be accounted for as bad debts and can be readily written off.