Question 2 (b)

Overcoming the shortcomings of the payback period

3 marks

Time to write: About 6 minutes
Topic: Capital budgeting techniques

Question

Question 2 (b) · 3 marks

How can the shortcomings of the Pay-Back Period (PBP) technique be overcome?

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

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6 minfor 3 marks

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HowHow it works or is done, step by step.

Write it in this order

1 Discounted payback period 1 mark 2 min
2 Post-payback profitability: flows after payback 1 mark 2 min
3 Payback as a screen, with a discounted cash-flow method to decide 1 mark 2 min

123

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Solution

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

Shortcomings. The payback period ignores the time value of money, ignores the cash inflows after the payback period, uses an arbitrary cut-off period, and so cannot measure profitability.

Picture itOvercoming the shortcomings of the payback period

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.

How they can be overcome

Discounted payback period (time value of money). Discount each year's cash inflow at the cost of capital and find the time the cumulative discounted inflows take to recover the outlay. Because it uses discounted flows, it is superior to the simple payback period.
Post-payback profitability (flows after payback). Add up the cash inflows expected after the payback period (and the salvage value). A project with a long life after payback is then not penalised against a short-lived one, and the criterion begins to reflect profitability.
Use payback with a discounted cash-flow method (cut-off and profitability). Use payback only as a first screen of liquidity and risk, for which it is suited. Then accept or rank the projects that pass it by NPV, IRR or the profitability index, which consider all cash flows over the project's life and their timing.

Where the 3 marks sit

#	Component	Marks
1	Discounted payback period	1
2	Post-payback profitability: flows after payback	1
3	Payback as a screen, with a discounted cash-flow method to decide	1
	Total	3

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