Question

1- What is the major criticism of the payback and simple rate of return methods of making capital budgeting decisions?

2- What is meant by the term "Payback Period"? How is the payback period determined? How can the payback period be used?

Answer 1

ANSWER 1

Major criticism of payback period

* payback method does not consider the time value of money

* it doesn't consider the cash flow get in the later years.it is short term benefits focused method

* it doesn't consider the project profitability. It focus only on the cost recovery period

*payback method does not consider the rate of return of a project

Major criticism of simple rate of return method

* it doesn't consider cashflow. This method use operating profit instead of cash flow

* simple rate of return method also ignore the time value of money

ANSWER 2

Payback period

Payback period is a period in which the inventor can recoup or recollect the invested amount in a capital investment project or it is the period to reach the break even point. It is one of the method used in capital investment decisions.  

How playback period is determined

If the investment of a particular project can be recollected from a for example 5 year . This 5 years is the pay back period of that project .

For example or how can payback period works

The investment of a project x is $100000 .

Cash in flow from x project are as follows

Year 1 $20000

Year 2 $50000

Year 3 $30000

Year 4 $50000

Year 5 $70000

Payback period of project x

$ 20000 recovered in year 1

$ 50000 recovered in year 2

$ 30000 recovered in year 3

So the payback period of project x is 3 years

USES OF PAYBACK PERIOD

* Payback method is mainly used to risk assessment

* it can be used to measure the liquidity of a project

* payback method is the most simplest and inexpensive method of capital investment decisions

The above are the detailed explanation of questions