Question

A firm may choose a project with a rapid payback period rather than one with a larger net present value. Discuss the validity of this statement.

Answer 1

A project with better payback period may not be good when compared with NPV method.

The payback method calculates the numbers of years required to recover the original investment in a project.

The basic drawback of the payback method is that it does not considers the cash flows after the payback period is reached.

Consider the below example for project A and B. Both the projects are for the same period of time, however while making capital budgeting decisions using the payback period method, project B is selected as it generates more inflow in the earlier years as compared to project A which has a higher NPV. However while considering NPV method Project A should be selected as it generates positve net cash flows for the business.

Year	Project A	Project B
0	$(1,000.00)	$(1,000.00)
1	$     400.00	$     500.00
2	$     400.00	$     500.00
3	$     400.00	$     100.00
4	$     400.00	$       10.00
5	$     400.00	$       10.00
Required Rate of Return	10%	10%
NPV	$516.31	($44.06)
Payback Period	2.5	2