Financial Management

M3 A1Financial mangers make decisions today that will affect the firm in the future. The dollars used for investment expenditures made today are different from the cash flows to be realized in the future.

What are these differences?

Money has a time value. A dollar today is worth more than a dollar in the future for the simple reason that a dollar can be invested today to yield more than a dollar in the future. When an investment involves cash flows over many years, this time value of money becomes important and should be taken into account in investment decisions. Simply adding together cash flows from different periods is like adding apples and oranges; dollars in different periods have different values.

Some investments involve a simple annuity, which is a series of identical cash flows that begin at the end of the first period and continue for a total of n periods into the future. The present value of such an annuity can be computed as the sum of individual present value factors, through the use of annuity tables, or using a formula.

What are some of the techniques that can be used to adjust for these differences?

The payback method is one of the techniques used in capital budgeting that does not consider the time value of money. The payback method simply computes the number of years it will take for an investment to return cash equal to the amount invested. For example, if an investment of $100,000 is made and it generates cash of $50,000 for two years followed by $10,000 per year for four additional years, it’s payback is two years ($50,000 + $50,000). If another investment of $100,000 generates cash of $20,000 per year for two years and then provides cash of $40,000 per year for six additional years, its payback is approximately 3.5 years ($20,000 + $20,000 + $40,000 + 0.5 times $40,000).Payback only answers one question: How long before the cash invested is returned? Payback does not address which investment is more profitable. Payback not only...