Question

Why are the payback and discounted payback measures often calculated when we know they are inferior to other methods in the capital budgeting process? Explain fully.

Answer 1

Payback and discounted payback measures are inferior to other methods for the following reasons:

• Payback measure does not account for the time value of money
• Discounted payback measure accounts for the time value of money but there is no objective way of saying what discounted payback period is acceptable for a project. Example: The same project having the same discouted payback period can either be accepted or rejected based on what the manager of each project thinks an accpetable payback period.

However, Payback and discounted payback measures are still widely used because of their simplicity in calculation. This is the only reason they still exist.