Question 2 OR (a)
Payback: a measure of liquidity more than of profitability
6 marks
- Time to write
- About 12 minutes
Question
Question 2 OR (a) · 6 marks"The Payback period is more a method of liquidity than of profitability". Explain the statement, explaining the payback method of capital budgeting. Also explain how the discounted Payback period improves on the traditional payback period method?
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
- Explain…Explain…?Two asks in one question: answer both.
- ExplainTie the answer to the quoted statement: say what it means first, 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 method explained 2 marks 3 min
- 2 Liquidity rather than profitability 2 marks 3 min
- 3 Discounted payback as an improvement 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 method. The payback period is the time a project takes to recover its initial outlay from its cash inflows: with equal annual inflows, payback = initial investment ÷ annual cash inflow; with unequal inflows, the cumulative inflows are added until they equal the outlay. A project is accepted if its payback is within the cut-off period set by management, and projects are ranked by shorter payback.
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 measures liquidity rather than profitability.
- Its emphasis is on the early recovery of the investment, which gives insight into the project's liquidity: the funds released can be put to other uses.
- A shorter payback also means less risk, since cash flows further away are less certain.
- But it ignores the cash flows after the payback period and the time value of money, and uses an arbitrary cut-off; it discriminates against projects with large later inflows, so it cannot be considered a measure of profitability.
So the statement is correct: payback tells how quickly the money comes back, not how much the project earns over its life.
How the discounted payback improves on it. The discounted payback period discounts each year's cash inflow at the required rate before cumulating them, and finds when the discounted inflows recover the outlay. Because it uses discounted flows, it takes account of the time value of money and is considered superior to the simple payback. It is still silent about flows after the payback point.
Where the 6 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Payback method explained | 2 |
| 2 | Liquidity rather than profitability | 2 |
| 3 | Discounted payback as an improvement | 2 |
| Total | 6 |
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