Question

QUESTION6 A company uses the payback method to evaluate capital budgeting projects. It is currently considering projects A, B and C125 ProjectA Project B Project C Initial cost (cash outflow) Cash inflows: $10,000 $10,000 $10,000 1st year 2nd year 3rd year a) $1,000 $9,000 $15,000 $10,000 $1,000 5,000 5,000 $35,000 Find the payback period for each of the above capital budgeting projects. Label the payback period fo-each prejectsol see which payback period goes with which project. b) What two major weaknesses of the payback method areillustrated by this problem? Explain each. Attach Fle Browse My Computer Browse Content Collection

Answer 1

Answer a)

Project/ Year	A	B	C
Year 0	-$10,000	-$10,000	-$10,000
Year 1	$1,000	$10,000	$5,000
Year 2	$9,000	$1,000	$5,000
Year 3	$15,000	$0	$35,000
Payback period in years	2 Years	1 Year	2 Years

Project A & C both have payback period of 2 years, whereas Project B has payback period of 1 year

Answer b)

The object of the payback method is to determine the number of years that it takes to recover the initial investment.

The disadvantages of Payback method are:

1) Ignores the time value of money:

Cash flows received during the early years of a project get a higher weight than cash flows received in later years. Two projects could have the same payback period, but one project generates more cash flow in the early years, whereas the other project has higher cash flows in the later years. e.g. Cash inflows from Project B is the highest in 1st Year as compared to Projects B & C

2) Neglects cash flows received after payback period

For some projects, the largest cash flows may not occur until after the payback period has ended. These projects could have higher returns on investment and may be preferable to projects that have shorter payback times. e.g. Project C has largest Total cash inflows but occurs after the payback period.

3) Does not consider a project's return on investment

Some projects require capital investments to exceed a certain hurdle of rate of return; otherwise the project is declined. The payback method does not consider a project's rate of return.