Module 5 BHS427 Health Care Finance (AUG2014-1) Capital Budgeting Essay

Module 5 BHS427 Health Care Finance (AUG2014-1) Capital Budgeting (CASE) - Essay Example is referred to as the time it takes a firm to recover its initial cash expenditure from the cash inflow it gets from a certain project or investment. Academics usually advocate the NPV method followed by IRR measure. The payback period method serves as a supplementary tool to decision making. The payback period is quite attractive, but its shortcomings make it less practically relevant. Its shortcomings include; the lack of consideration of the time value of money that can influence wrong decision-making and, it also ignores any cash flows which accrue after the payback period. Despite its shortcomings, the payback period method is still used by firms in appraising capital budgeting decisions (Avery, 2011). The continual use of the payback period by firms and managers implies that there is value realized from its results. Thus, considering a constant growth rate of cash flows the payback period can be calculated by using two main factors of cash flow. The factors are â€Å"the ratio (I) of the initial outlay to the next period projected cash flow, and the projected cash flow growth rate (g)† (Avery, 2011., p.1). Therefore, if the payback period is negatively associated to g and positively related to the ratio I, the management is at a better position to evaluate the expenses and gains of a certain project. Money time value can be adjusted via the discounted cash flows. This approach suggests that there is an expected constant growth in cash flows; choosing the value of g depends on existing knowledge of the activity and foresight of a firm. The ratio I will be the initial investment divided by 1. The cash flow is also assumed to be growing â€Å"at a constant rate of g percent per period.† Thus from calculations the payback period (T) is directly proportional to I, and inversely proportional to g. That is; a high value of I imply a high initial investment cost as compared to the projected first period cash flow. Hence, an investor will take a longer time to