Can Cost Cutting Turn Out to be Expensive?
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Disadvantages of Securitization in Sports
In the previous articles, we have already seen how the use of securitization has grown in sports. We also know that the increasing use of securitization is because of certain benefits that are provided by this method of raising capital. However, it is important to note that securitization is a part of structured finance. Structured […]
Catastrophe Bonds
Catastrophe bonds are one of the most sophisticated tools used by the insurance company in order to protect itself from mounting losses. The fact that more than $12 billion worth of catastrophe bonds have been issued in the year 2019 is a testimony to their popularity. Catastrophe bonds are a form of ultra-high-risk debt which […]
Financial Modeling: Important Metrics
Financial modeling can be considered to be the science of making informed decisions regarding a company based on data simulations. Most financial models pay keen attention to a variable such as revenue and expenses as well as their drivers. Data regarding these variables is extensively collated as well as analyzed. However, it turns out that […]
Different Types of Accounts in a Business
The entity concept separates the concerns of the owners from the business. An extension of the same concept is the concept of accounts which splits up the business’s affairs further. The account concept becomes clearer once the double entry system of accounting is explained. That is done at a later stage in the tutorial. Transactions […]
We have earlier discussed the fact that Net present Value (NPV) is considered to be the gold standard when it comes to financial decision making. If a project has an NPV greater than zero then it is supposed to be a financially viable project and the firm must invest its resources towards that project, if not the project should be rejected.
But NPV is not the only metric that we can use to come to this decision regarding accepting or rejecting a project. Payback period is another such metric. In this article we will discuss about the conceptual foundation of payback period and then we shall see its drawbacks.
Payback period basically pays attention to the speed at which the initial investment made in a project will be recovered by subsequent cash flows. The project which helps recoup the investment the fastest is considered to be the best project and that is the project that the firm must dedicate its resources to.
Example:
Let’s say that there are 2 projects A and B. Both require an equal outlay of $2000. Project A pays back $1500 in year 1, $500 in year 2 and $500 in year 3. Project B on the other hand pays $750 for 4 consecutive years.
So, now in this case if we were to use the payback period rule. We could consider the period in which the initial $2000 investment is recovered. In case of Project A, we recover it in 2 years whereas in case of Project B it requires 3 years. So according to the payback rule, Project A is better than Project B and the company must clearly devote its finite resources to Project A before it decides whether or not to undertake Project B.
Now, this decision could be wrong because of a couple of reasons:
To overcome the second limitation of ignoring the time value of money, a modified measure of payback period called the discounted payback period is often used. This measure still does not overcome the fact that payback period does not account for the cash flows after the initial investment has been recouped. This is the reason why payback period is not a perfect metric and why NPV leads to better decisions.
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