Which one of the following statements is correct? A. A longer payback period is

Question

Which one of the following statements is correct?
A. A longer payback period is preferred over a shorter payback period.
B. The payback rule states that you should accept a project if the payback period is less than one year.
C. The payback rule ignores the time value of money.
D. The payback rule is biased in favor of long-term projects.
E. The payback rule considers the timing and amount of all of a project's cash flows.

1) Explain why C. is the correct answer.
2) Explain why E. is not the correct answer.
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Thank you.

Explanation / Answer

C Tricks of the Trade Clearly, a main defect of the straight payback period method is that it ignores the time value of money principle, which, in turn, can produce unrealistic expectations. A second drawback is that it ignores any benefits generated after the payback period, and thus a project that would return $1 million after, say, six years might be ranked lower than a project with a three-year payback that returns only $100,000 thereafter. Another alternative to calculating by payback period is to develop an internal rate of return. Under most analyses, projects with shorter payback periods rank higher than those with longer paybacks, even if the latter promise higher returns. Longer paybacks can be affected by such factors as market changes, changes in interest rates, and economic shifts. Shorter cash paybacks also enable companies to recoup an investment sooner and put it to work elsewhere. Generally, a payback period of three years or less is desirable; if a project’s payback period is less than a year, some contend it should be judged essential.

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