Answer to Question #18799 in Finance for Tamara

Question

Suppose a firm relies exclusively on the payback method when making capital budgeting
decisions, and it sets a 4-year payback regardless of economic conditions. Other things held
constant, which of the following statements is most likely to be true?

Answer 1

The payback method is not a true measure of the profitability of an investment. Rather, it simply tells the manager how many years will be required to recover the original investment. Unfortunately, a shorter payback period does not always mean that one investment is more desirable than another.
Another criticism of payback method is that it does not consider the time value of money. A cash inflow to be received several years in the future is weighed equally with a cash inflow to be received right now.
If the firm sets a 4-year payback regardless of economic conditions it won’t be effective.
If the 4-year payback results in accepting just the right set of projects under average economic conditions, and then this payback will result in too few long-term projects when the economy is weak.
Under certain conditions the payback method can be very useful. For one thing, it can help identify which investment proposals are in the "ballpark." That is, it can be used as a screening tool to help answer the question, "Should I consider this proposal further?" If a proposal does not provide a payback within some specified period, then there may be no need to consider it further. In addition, the payback period is often of great importance to new firms that are "cash poor." When a firm is cash poor, a project with a short payback period but a low rate of return might be preferred over another project with a high rate of return but a long payback period. The reason is that the company may simply need a faster return of its cash investment. And finally, the payback method is sometimes used in industries where products become obsolete very rapidly - such as consumer electronics. Since products may last only a year or two, the payback period on investments must be very short.