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Use of the Payback Period

According to Avery, Flaherty, and Rhee (2011), when choosing a capital budgeting decision tool, academics recommend net present value (NPV) as the primary tool followed by the internal rate of return (IRR) measure. The payback period method is also presented but is treated as a decision aid. As a decision tool, the payback period measure is typically regarded as intuitively appealing but with little practical relevance due to its shortcomings. In order to further evaluate the usefulness of the payback period, please read the following article: Fortifying the payback period method for alternative cash flow patterns by Avery, Flaherty, adn Rhee.

After reading the article and using other resources, please respond to the following questions.
1. Identify and discuss the payback period.
2. If the payback period method is inferior relative to present value techniques, why are firms still using it as a primary decision tool?
3. Summarize what the authors discussed about payback period with constant growth and without discounting.
4. Summarize the author's discussion on payback period with discounting.
5. Based upon what you have read in this article, do you agree with the statement that payback period has little practical relevance? Why or why not?

Solution Preview

1. Identify and discuss the payback period.

The payback period, T, is the length of time it takes to recover the initial investment of a capital investment proposal. The first period cash flow is assumed to be $1 so the ratio I will be the initial investment divided by 1 or simply the initial investment. Since the payback period is the length of time to recover the initial investment. The payback period T can be easily found using a factor to calculate future value of an annuity. The Future Value Interest Factor

Figure 2 plots the relationship between payback period , T, and the investment period to first period cash inflow ratio, I for given values of growth rate g. As I becomes larger the payback period increases. The rate of increase depends on the value of g. When the growth rate g is negative, the payback period increases exponentially as the ratio I becomes larger and the payback curve is convex in shape. The concavity increases as the growth rate increase demonstrating that the increase in payback period T is diminished at high growth rate.

2. If the payback period method is ...

Solution Summary

740 words on how the payback period is used as a decision tool, given the alternatives, using a given article.