Lockbox Service Provided by Banks
What is a Lockbox ? Lockbox is an additional service provided by banks in the United States. This service allows companies to drastically cut short or even eliminate the tasks that need to be performed by accounts receivables departments. The logic behind the lockbox system emanates from the concept of economies of scale. When every […]
Investment Banking and Delisting
It is common knowledge that investment bankers help a company when they want to list their shares on the stock exchange. This process is called listing, and there are hundreds of companies that undertake this process every year. However, the opposite of this process also happens. This means that companies that are already publicly listed […]
Testing the Financial Model
The creation of a financial model is like a project which has to be undertaken by the company. This means that just like any other project, testing the functioning of the financial model should ideally be included in the project. However, in most cases, testing the financial model is generally the last phase of the […]
How to Reduce Return Rates in Retail?
In the previous article, we have already seen that the return policy offered by a retailer can deeply influence their profitability as well as their cash flow. Over the years, retailers have realized the tactical importance of return rates. As a result, they have taken measures to reduce the same. In this article, we will […]
The Economics of ‘Soda Taxes’
Sugary beverages manufactured by companies such as Coca-Cola and Pepsi are colloquially called “soda” in the United States. Americans consume soda in large quantities. This consumption can be attributed to the fact that soda is easily and cheaply available. The low cost and easy availability are considered to be one of the main reasons why […]
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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