Question 3 (a)
Payback period: a measure of liquidity rather than profitability
6 marks
- Time to write
- About 12 minutes
Question
Question 3 (a) · 6 marks“The payback period is more a method of liquidity than of profitability”. Examine the statement, explaining the payback period method of capital budgeting.
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
Read from the question
- ExamineA statement to judge: take a stand on it in your first line, and come back to it at the end.
- payback periodCash flows year by year in one table, then discount, then a one-line decision.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Payback period method explained computation and decision rule 2 marks 3 min
- 2 Why it measures liquidity early recovery, risk screening 2 marks 3 min
- 3 Why it fails as a profitability measure, and conclusion 2 marks 3 min
- Check: every ask answered, key terms underlined 2 min
Short on time? Trim steps 1–3 evenly rather than skip one: each is capped at its own marks.
Try it first. About 12 minutes for 6 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.
The payback period method. The payback period is the number of years a project takes to recover its initial investment from its cash inflows. With equal annual inflows it is investment ÷ annual inflow; with unequal inflows the inflows are cumulated until they equal the investment, the fraction of the last year being found by interpolation. A project is accepted if its payback period is no longer than a cut-off period set by management (say three years), and rejected otherwise; between projects, the one with the shorter payback is preferred.
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.
Why it is a measure of liquidity. The method's emphasis is on the early recovery of the investment, so it shows how quickly the funds locked in a project come back and can be put to other uses: an insight into the project's liquidity. It also screens out risky projects, since inflows further in the future are less certain. It suits a firm with limited funds, or in unstable times, that wants its money back at the earliest opportunity.
Why it is not a measure of profitability.
- It ignores the time value of money: a rupee recovered in year 3 counts the same as one in year 1.
- It ignores the cash inflows after the payback period, however large, so a project that goes on earning for many years after recovery gets no credit for it.
- The cut-off period is arbitrary and is applied to all projects whatever their lives, so short-lived projects are favoured.
- Because it discriminates against projects whose inflows come in later years, it cannot be a measure of profitability.
Conclusion. The statement is correct. Payback answers "how soon do we get our money back?", a liquidity question. It does not answer "how much does the project earn over its life?", the profitability question that discounted methods such as net present value address.
Where the 6 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Payback period method explained (computation and decision rule) | 2 |
| 2 | Why it measures liquidity (early recovery, risk screening) | 2 |
| 3 | Why it fails as a profitability measure, and conclusion | 2 |
| Total | 6 |
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