Question

why is an investment more attractive to management if it has a shorter payback period? Should this be the only consideration? All things being equal, which of the methods covered in the chapter (including the payback method) would you choose and why?

Answer 1

There are some reasons for management to use payback period method.

(1) This method is easy to understand for users and also for stake holder. Other methods that use discounting factor are not easily understandable to all.

(2) Management always wants to be risk averse. Hence they want that investment should be collected fast.

(3) Shorter payback period is the criteria that is being used by the method of pay back.

Should this be the only consideration?

No, payback is not a recommended method or scientific style of selecting projects. Selecting a project with shorter payback period does not guarantee earning of minimum required rate of return for shareholders.

Post pay back profitability is ignored by payback period method. That means, a project may have shorter payback but may not have much life left or profitability there-after. But on the other hand a project having a bit higher payback may be rejected but it can have many years left after payback in which there is potential for huge earnings is ignored.

Under capital budgeting process, out of 5 methods, NPV ( Net Present value Method) is regarded as the best method. The main reasons for NPV being regarded as best one are

(1) It considers all the cash flows involved in the analysis. Unlike payback where profitability is measured only upto repayment time, NPV considers all cash flows from inception to end of life of the project.

(2) It uses the present value of money concept in valuing the cashflows. It is very essential to check whether the project is able to earn what it ought to earn. Otherwise, wealth will be destroyed for the firm.

(3) IRR, assumes cashflows are reinvested at that IRR rate itself. This makes IRR less comparable to NPV.

(4) NPV is an absolute measure, in the sense that final value is in dollar value but not in percentage. For example a higher IRR of 40% with just 4000 NPV is not a preferred choice over a project with 18% IRR with 180,000 of NPV. That means percentage terms ( relative measures) are some times misleading unless we take care of absolute values.