Question

1. Chapter 11 discusses the importance of the time value of money. Yet, one of the methods to evaluate projects is the payback method, which does not take the time value of money into consideration. So why would anyone use this method?

Answer 1

Under the payback period method, estimate how much it will cost your business to launch the project and how much money it will generate once it's up and running. Then calculate how long it will take the project to "break even," or generate enough money to cover the startup costs. Companies using the payback period method typically choose a time horizon – for example, 2, 5 or 10 years. If a project can "pay back" the startup costs within that time horizon, it's worth doing; if it can't, the project will be rejected. When deciding between projects, choose the one with the shorter payback period.

Many businesses use a combination of NPV and Payback period when making capital budgeting decisions. You could use the payback period method to narrow down options, then apply the NPV method to identify the best of the remaining projects. Or you could use the NPV method to separate the "winners" from the "losers" among possible projects, then look at payback periods to see which projects return their costs more quickly

However, there are advantages to using the payback period, which are as follows:

• Simplicity. The concept is extremely simple to understand and calculate. When engaged in a rough analysis of a proposed project, the payback period can probably be calculated without even using a calculator or electronic spreadsheet.

• Risk focus. The analysis is focused on how quickly money can be returned from an investment, which is essentially a measure of risk. Thus, the payback period can be used to compare the relative risk of projects with varying payback periods.

• Liquidity focus. Since this analysis favors projects that return money quickly, they tend to result in investments with a higher degree of short-term liquidity.