(ii) Evaluate appropriate sources of finance that could be used to fund the setting up a new factory for a privately family owned company.
(The company produces plastic trays and cups and has recently been offered a 15 year contract to produce plastic bottles by major world wide soft drinks manufacturer.)
Note: Most of the information that I have used in the answer I got from my class notes from my Corporate Finance class in graduate school and the textbook for that class. (Fundamentals of Corporate Finance--Sixth Edition; By: Ross, Westerfield and Jordan. 2003). I hope everything is clear and that I answered your question.
<br>Payback time should be considered. The payback time is the length of time it takes to recover the initial investment. Now the payback period is the amount of time required for an investment to generate sufficient cash flows to recover its initial time. An investment will be acceptable if its calculated payback period is less that the specified time required.
<br>The disadvantages of this method as compared to NPV is:
<br>1. The payback peirod is calculated simply by adding up the future cash flows, therefore time value of money is ignored.
<br>2. IT is calculated the same whether we are considering risky or safe projects.
<br>3. Ignored cash flows beyond the cutoff date.
<br>4. Biased against long term projects, such as research and development and new projects.
<br>Advantages of Payback Rule (Period)
<br>1. Used by organizations for making minor decisions--decisions that do not warrant detailed analysis because the the cost of analysis would exceed the possible loss from a mistake.
<br>2. Because it is biased towards short-term projects, its is biased towards liquidity. Basically this means that the payback rule favors projects that free up cash for other uses more quickly.
<br>3. Easy to understand
<br>Discounted Payback Period
<br>The discounted payback period is the length of time until the sum of the discounted cash flows is equal to the initial investment. Based on this rule an investment is acceptible if its discounted payback is less than some prespecified number of years.
<br>Advantages of the Discounted Payback Rule:
<br>1. Includes time value of money
<br>2. Easy to understand
<br>3. Does not accept negative estimated NPV investments
<br>4. Biased towards liquidity
<br>Disadvantages of the Discounted Payback Rule
<br>1. May reject positive NPV investments
<br>2. Requires an arbitrary cutoff point