Introduction and the Payback Period Approach

Question 1

Describe the payback period approach to project evaluation.

Answer 1

It determines the number of years (or other periods) needed to recover the initial cash investment in the project and compares the resulting time with a pre-established maximum payback period. It uses undiscounted expected future cash flows.

Question 2

Under what circumstances would the payback period approach to project evaluation be most appropriate?

Answer 2

• Used as a preliminary screening technique
• Used in conjunction with other evaluation techniques
• When recovery of cash (liquidity) is of critical importance

Question 3

Identify the advantage of the payback period approach to project evaluation.

Answer 3

• It is easy to use and understand
• It is useful in evaluating liquidity of a project
• Use of a short payback period reduces uncertainty

Question 4

Identify the disadvantages of the payback period approach to project evaluation.

Answer 4

• It ignores the time value of money.
• It ignores cash flows received after the payback period.
• It does not measure total project profitability.
• The maximum payback period may be arbitrary.

Question 5

Identify at least five different techniques for evaluating capital budgeting projects.

Answer 5

1. Payback period approach
2. Discounted payback period approach
3. Accounting rate of return approach
4. Net present value approach
5. Internal rate of return approach