Question

Evaluating Prospective Investments If we accept that the goal of the financial manager is to create value for the stockholder, it follows that the financial manager must have a means of evaluating a prospective investment in terms of its likelihood of enhancing shareholder value. Different decision criteria may be used to evaluate proposed investments and we have gone through a pretty thorough review of most of them (NPV, IRR, Payback Period (straight and discounted), AAR, MIRR, PI). Our review included learning how to calculate each one as well as come to an understanding of the advantages and disadvantages of each. “Conventional wisdom” tells us that only the NPV criterion can always tell us if a particular project is a good investment and, if we have more than one project from which to choose, which one we should take. If this is the case, then why do so many financial managers in the “real world” make extensive use of the payback approach and, typically, do not take a discounted approach to payback? If you were to counsel a financial manager who is committed to using a payback criterion to evaluate prospective investments, would you take the opportunity to discuss other decision criteria that might be used? What advice would you provide as to whether he/she should continue using payback or if he/she should consider another approach and why?

Answer 1

Several financial managers in the ‘real world’ make extensive use of the payback approach because of the fact that this approach is quite simple and easy to use. Besides its ease of use this concept can easily be communicated to different stakeholders of a company who may not have a comprehensive or a proper knowledge of finance and capital budgeting techniques. Also the payback method works well in case of uncertainty. Lastly when there is preference for liquidity then this method is most useful as a project with a shorter payback has lower liquidity risks associated with it.

Yes, if I were to counsel a financial manager who is committed to using a payback criterion to evaluate prospective investments, I would certainly and definitely discuss other decision criteria that might be used. My advice will be that the manager should consider another approach as other approaches like NPV, IRR, MIRR (modified internal rate of return) are far more superior and takes into consideration the time value of money. These methods are more realistic and more practical and hence the objective of value maximization is more realistically realized.