Share
Explore BrainMass

Payback period and capital-budgeting technique

Study Question 9-2 on page 286

What are the criticisms of the use of payback period as a capital-budgeting technique? What are its advantages? Why is it so frequently used?

Study Problem 9-5

You are considering a project with an initial cash outlay of $80,000 and expected free cash flows of $20,000 at the end of the year for 6 years. The required rate of return for this project is 10 percent.

A. What is the project's payback period?

b. What is the project's NPV?

C. What is the project's PI?

D. What is the project's IRR?

Study Problem 9-18

(Capital rationing)The Cowboy Hat Company of Stillwater, Oklahoma, is considering seven capital investment proposals, for which the funds available are limited to a maximum of $12 million. The projects are independent and have the following costs and profitability indexes associated with them.

Project Cost Profitability Index
A $4,000,000 1.18
b 3,000,000 1.08
C 5,000,000 1.33
D 6,000,000 1.31
E 4,000,000 1.19
F 6,000,000 1.20
G 4,000,000 1.18

A. Under strict capital rationing, which projects should be selected?

B. What problems are there with capital rationing?

My textbook for this class is Foundations of Finance by Keown, Martin, Petty, Scott Jr. The fifth edition.

Solution Preview

What are the criticisms of the use of payback period as a capital- budgeting technique? What are its advantages? Why is it so frequently used?
This I have discussed in the previous response. I will just explain again:

Under the Payback Method, we compute the amount of time required for an investment to generate cash inflows sufficient to recover its initial cost. Based on this method, an investment is acceptable if its calculated payback period is less than some pre specified number of years.
Criticism
This method is least accurate because it suffers from some important shortcomings:
(1) The payback period is calculated simply by adding up the future cash flows. There is no discounting involved, so the time value of money is completely ignored. (2) The payback rule also fails to consider risk differences. The payback would be calculated the same way for both very risky and very safe investments. Finally, the payback method completely ignores all cash flows beyond the payback period. Moreover there is no rational for the cut off period. There is also bias for short term projects.

Advantages:
But this method is used so often because:
1) It is easiest to use as it is very simple to calculate and easy to comprehend
2) Thus it's cost effective
3) It tells the short-term ...

Solution Summary

This solution discusses the criticisms of the use of payback period as a capital-budgeting technique and provides answers to various questions involving project's payback period, NPV, PI, and IRR.

$2.19