Question 1 (b)

True or false: profit criterion; payback as a liquidity measure

10 marks

Time to write
About 20 minutes

From an older CBCS paper

Question

Question 1 (b) · 10 marks

State, with reasons, whether each statement below is true or false

  1. For making financial decisions, Profit it is not an operationally feasible criteria

  2. Payback period is a method of liquidity, rather than of profitability

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

20 minfor 10 marks

Read from the question

  • true or…A verdict for each (True or False), then the reason that decides it.
  • Payback periodCash flows year by year in one table, then discount, then a one-line decision.

What the paper leaves open

"Profit it is not an operationally feasible criteria" is kept as printed.

Write it in this order

The parts stand alone: start with the one you are surest of.

A step that gives the answer away stays hidden: tap it to see it.

  1. Read each statement; find the word that decides it 1 min
  2. 1 (i) verdict, with the reasons why profit is not operationally feasible 5 marks 9 min
  3. 2 (ii) verdict, liquidity emphasis and why it does not measure profitability 5 marks 9 min
  4. Check: a verdict and a reason for every statement 1 min

Short on time? A few lines on every part beat a full answer to one: each part is capped at its own marks.

Try it first. About 20 minutes for 10 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

(i) "For making financial decisions, profit is not an operationally feasible criterion": True.

Profit maximisation makes the finance manager choose whatever raises profit, but as a criterion for decisions it fails on several counts:

Picture itTrue or false: profit criterion; payback as a liquidity measure

1Rekha puts her savings into a juice cart—the jar on the counter starts empty.

Payback periodThe number of years a project takes to recover its initial investment from its cash inflows.

2Orange by orange, the jar fills back towards what the cart cost her.

Why it is a measure of liquidityHow quickly the funds locked in a project come back and can be put to other uses.

3The jar full, the counting stops—the measure never looks at all the selling still to come.

Why it is not a measure of profitabilityIt ignores the cash inflows after the payback period, however large.

  1. It is vague: "profit" may mean short-term or long-term, total profit or rate of profit, before or after tax, so it gives no precise rule for choosing between alternatives.
  2. It ignores risk: risky proposals often promise high profits; a profit criterion would accept them without weighing the risk.
  3. It ignores the timing of returns: a proposal with larger profits that arrive ten years later may be worse than one with smaller but earlier returns; the time value of money is ignored.
  4. It is too narrow: it overlooks the firm's obligations to workers, consumers and society.
  5. It ignores the financing side: a profitable project may be financed in a way (heavy borrowing, say) that loads the shareholders with risk, and a profit rule does not weigh that risk.

The DU SOL text sums up the modern view: in today's business environment profit maximisation is regarded as unrealistic, difficult and inappropriate as a goal.

For these reasons profit maximisation is unsuitable as an operational objective of financial management; wealth (value) maximisation, which uses the present value of cash flows discounted for risk, is used instead: it is the accepted operational criterion for financial decisions.

(ii) "Payback period is a method of liquidity rather than of profitability": True.

The payback period is the time a project takes to recover its outlay from its cash inflows. Its emphasis is on the early recovery of the investment, so it shows how soon the funds come back and can be put to other uses: an insight into the project's liquidity. But it does not measure profitability, because:

  1. it ignores the time value of money;
  2. it ignores all the cash inflows after the payback period;
  3. its cut-off period is arbitrary and favours short-lived projects;
  4. it discriminates against projects whose large inflows come later, so it cannot be a measure of profitability.

Where the 10 marks sit

#ComponentMarks
1(i) verdict, with the reasons why profit is not operationally feasible5
2(ii) verdict, liquidity emphasis and why it does not measure profitability5
Total10
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