What is Prototyping?
In the previous articles, we have already studied about the proof of concept as well as the minimum viable product concept. However, there is one more methodology that is commonly used in the product development stage after the seed funding has been received. This mechanism is known as “prototyping”. In this article, we will further […]
The Impact of Shrinkage on Finance in the Retail Industry
The retail industry is unique in many ways. There are several financial and operational concepts which are more relevant to the retail industry than to other industries. Shrinkage is one such concept which has more relevance in accounting for the retail industry. In this article, we will have a closer look at the concept of […]
Constraints and Contribution Margin Analysis
Hidden Assumption: The cost volume profit analysis has a rogue assumption. This rogue assumption believes that the cost volume profit analysis is completely scalable. We know that this is not the case. We operate in a finite world and have finite resources. We show this in our analysis when we write down the relevant range […]
Advantages and Disadvantages of Swingline Loans
In the previous article, we have already studied what Swingline loans are. We now know that such loans are different from revolving credit which is offered by many commercial banks. Over the years, Swingline loans have come to occupy a very important place in commercial banking. There are some people who believe Swingline loans are […]
Municipal Bonds
We already know that bonds are issued by a wide variety of entities. Bonds are routinely issued by corporations, banks, and even governments all over the world. A special category of bonds called municipal bonds (munis) are issued by various local governments across the globe. These bonds are often categorized separately because they have certain […]
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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