Question

Why is an investment more attractive to management if it has a shorter payback period? Should this be the only consideration? Explain.

Answer 1

Pay back period - The pay back period is the time frame in. Which u tend to earn from the net cash flow of investment, an amount equal to the investment made. For eg : if you invested $1000 so the time in which $1000 will be earned in gross from the cash flow of such investment is termed as pay back period.

Why is short pay back period more attractive?

Shorter pay back period means the amount invested is recovered in short period of time, which means the risk associated with the capital sum invested will be reduced to zero. From then the investment will earn the profit margin as our investment amount has been recovered. Thus, shorter pay back period is more attractive for the managers.

Is this the only consideration?

No, short time period is not the only consideration for determining a suitable investment plan. The major drawback of pay back method is that it ignores the time value of money.

Hence there are many other considerations as follows :-

The amount of investment

Pattern of cash flow expected

Time value of money

Hence it is not the only consideration, there fore

The net present value of the net cash flow

The internal rate of return

Are the two appropriate approaches to determine the best investment opportunities.