Which of the following statements about the payback period method of investment appraisal is true? The...

Which of the following statements about the payback period method of investment appraisal is true? The method

A Does not consider all of the net cash flows for an investment

B Considers the time value of money

C Depends on the cost of capital of the company

D Is a measure of an investment’s profitability

Expert Solution

Solution:-

Payback period is a method of capital budgeting which relies on the time period of recouping initial investment to analyse the viability of the project. The method calculates the number of years in which the initial investment made will be recouped and this period is called payback period. If the payback period is less than the desired levels, the investment should be accepted and vice-versa.

So, as we can analyse from the above definition the payback period is calculated using only the initial investment outflow and cash inflows that recoup that investment. This doesn't take into consideration for decision making the further cash inflows which earn a return over and above the recoup of investment.

Let's take an example as follows:

A project requires an initial investment of $100m today and will earn $20m per year for the next 10 years. In this case, the combined cash inflows of first 5 years amounts to $100m (i.e. $20m*5) which recoups the initial investment. So, the payback period becomes 5 years. The method doesn't conisder in any way the cash inflows of year 6 to year 10 for the purpose of decision making.

Analysis of all options:-

Option A: As per above explanation, the statement is true and hence this option is correct

Option B: The payback period considers absolute cash flows and not discounted cash flows. Therefore, it doesn't consider the time value of money and the statement is incorrect

Option C: Since there is no discounting of cash flows, it doesn't depend on cost of capital and the statement is incorrect

Option D: It is not a measure of project's profitability but simply measures the number of years in which investment will be recouped. Therefore, the statement is incorrect

Hence, based on above analysis, the correct option is option A.

jeff jeffy answered 2 years ago

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