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4. (7 points) Please list at least one advantage and one disadvantage of payback period rule. Please also explain payback per
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Answer #1

Payback period refers to the time when the firm is able to recover its initial investment.

Formula- Pay-back period = Initial Investment/ Net Cash Inflows

So, as per the pay-back period rule , the lower the pay-back period , better it is since the firm can recover its investment at an early date and has opportunity to invest in some other projects.

Advantages-

1. It is very simple to ascertain

2. It helps to assess the investment risk

3. Good for short-term forecasts

Disadvantages-

1.Ignores the time value of money

2.It is not in consensus with the objective of maximisation of sharehoder's wealth.

3. Ignores the cash flow after the pay-back period.

This pay-back rule method is employed by usually small business because it is a good indicator of liquidity and is very easy to calculate and provides a rough idea of effeciency.

It is even employed by the large scale business too but with other methods like NPV Analysis, IRR etc.

Moreover, today , the firms are tending towards the Modified Pay-Back method which incorporates the time value of the money and hence tries to abrogate the disadvantages of the Pay-back rule.

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