Describe how the payback period is calculated and describe the information this measure provides about 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? What are the problems associated with using the payback period as a means of evaluating cash flows? What are the advantages of using the payback period to evaluate cash flows?

Expert Solution

Describe how the payback period is calculated and describe the information this measure provides about a sequence of cash flows.
ANS:Payback period is calculated by dividing initial investment by cash inflow per period. Payback period is basically the time taken to recover the initial investment. For example, if intial investment for a project is $10 Lakh and cash flow generated by that project every year is $2 lakh then payback period will be 5 years.

What is the payback criterion decision rule?
ANS: The project should be accepted only if its payback period is less than the target payback period.

What are the problems associated with using the payback period as a means of evaluating cash flows?
ANS: Firstly, payback period neither take into account the time value of money nor the cash flows that occur after the payback period.
Secondly, it tends to ignore projects profitability, every projects having short payback period might not be profitable. This in turn can lead to wrong decision making.

What are the advantages of using the payback period to evaluate cash flows?
ANS:Firstly, it helps in evaluating a good ranking of the projects that would return money early. This may help the companies which are facing liquidity problems.
Secondly, it helps to measure the amount of risks associated with the project. Lastly, it is simple to calculate.

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