Choose The Correct Statement Involving The Statement Of Cash Flows Payback Period Method

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Payback Period Method

Payback is the number of years required to recoup the initial cash flow of the investment in the project. Payback is one of the most popular and widely recognized traditional methods of evaluating investment proposals. If the project generates consistent annual cash inflows, the payback period can be calculated by dividing cash outlays by annual cash inflows. That is:

Payback = initial investment / annual cash flow

Acceptance rule

Many companies use the payback period as a measure of investment evaluation and a method of ranking projects. They compare project returns to a predetermined, standard return. The project would be accepted if its payback period was less than the maximum or standard payback period set by management. As a ranking method, it gives the highest ranking to the project with the shortest payback period and the lowest to the project with the highest payback period. Therefore, if a company has to choose between two mutually exclusive projects, the project with the shorter payback period will be chosen.

Advantages of Payback

Payback is a popular investment criterion in practice. It is considered to have certain virtues.

• Simplicity. The most important advantage of payback is that it is easy to understand and calculate. Business executives see the simplicity of the method as a virtue. This is evident from their heavy reliance on it when evaluating investment proposals in practice.

• Cost effective. The payback method costs less than most sophisticated techniques that require a lot of analyst time and computer use.

• Short-term effect. An investor can achieve more favorable short-term effects on earnings per share by setting a shorter standard payback period. However, we must remember that this may not be a wise long-term policy, as the investor may have to sacrifice his future growth for current earnings.

• Shield against risk. We can talk about project risk with a shorter standard payback period, as it can provide a guarantee against loss. An investor has to invest in many projects where cash flows and life expectancy are highly uncertain. In such circumstances, payback may become important, not so much as a measure of profitability, but as a means of setting an upper limit on the level of acceptable risk.

• Liquidity. The emphasis in the return is on the early recovery of the investment. This gives an insight into the liquidity of the project. The funds released in this way can be used for other purposes.

Disadvantages of Payback

In the spirit of its simplicity and so-called virtues, profitability may not be a desirable investment criterion, as it has a number of serious limitations:

• Cash flows after repayment. The refund does not take into account cash inflows earned after the refund period.

• Cash flows are ignored. Payback is not an appropriate method for measuring the profitability of investment projects, as it does not take into account all the cash inflows that the project brings.

• Cash flow patterns. Payback does not take into account the pattern of cash inflows. That is the volume and timing of cash inflows. In other words, it gives equal weights to returns of equal amounts even though they occur at different time periods.

• Administrative problems. The company may face difficulties in determining the maximum acceptable payback period. There is no rational basis for determining the maximum payback period. In general, this is a subjective decision.

• Inconsistent with shareholder value. The return is inconsistent with the objective of maximizing the market value of the companies’ shares. Share values ​​do not depend on the payback periods of investment projects.

Let us emphasize again that payback is not a valid method for evaluating the acceptability of investment projects. However, it can be used in conjunction with net present value rules as a first step in a rough screening of projects. In practice, the use of discounted cash flow techniques is increasing, but payback still remains the popular and primary method of investment valuation.

Reimbursement is considered theoretically useful in a few situations. One important argument in favor of the return is that its reciprocity is a good approximation of the rate of return under certain conditions.

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