Question

Net Present Value and Other Investment Criteria

Payback Period - Concerning payback:

a. Describe how the payback period is calculated, and describe the information this measure provides about a sequence of cash flows. What is the payback criterion decision rule?

b. What are the problems associated with using the payback period to evaluate cash flows?

c. What are the advantages of using the payback period to evaluate cash flows? Are there any circumstances under which using payback might be appropriate? Explain.

250 Words.

Answer 1

a) Payback period shows in how much time initial cash outflow will be recovered. Here it is assumed that the cash flows are occuring through out the year and not on some point of time. In other words Payback period is break even point of series of cash flows. Payback period is caluclated as follows

Initial Investment / Annual cash Inflow

Given some predetermined cutoff for pay back period, Accept the project if payback period is within the predetermined cutoff or reject the project if payback period is outside predetermined cutoff

b) Following are the problem associated with payback period

1) It does not consider time value of money

2) It does not consider number of/size of cash flow after the predetermined cutoff thus making it biased towards short term projects

c) Advantages of using payback period

1) It is simple to calculate and straight forward

2) Accounting information is readily available

Since payback period focuses on liquidity, it may be useful to analysis short term project where cash management is important.