Question

Why might it be rational for a small firm that does not have access to the capital markets to use the payback method rather than the NPV method?

Answer 1

Payback period helps us to calculate basically when is the project going to breakeven. It is a kind of measure of liquidity and risk. The shorter the payback period the higher the liquidity and lower the risk. For firms which do not have ready access to capital markets liquidity is very important for their day to day business needs. So therefore it makes sense if small firms to use payback period method instead of NPV for evaluating projects because of the liquidity and related risk factors.