3.8 Payback Period

The Payback Period is measured in terms of ___

• currency ($ or £)

• years/months

• Percentage %

• quantity

Which of the following is an example of an investment decision by a construction company?

• A decision to pay lower dividends to its shareholders

• A decision to purchase a new cement mixing machine

• A decision to sell an obsolete timber cutting machine

• A decision to increase a bank overdraft to ensure sufficient working capital

Answer explanation

The decision to purchase a new cement mixing machine is an investment decision for a construction company, especially as the business will need to assess and justify the capital expenditure in terms of whether it will be profitable.

Which of the following attributes is not an advantage of the payback period method of investment appraisal?

• It ignores the overall profitability of an investment

• It is simple and relatively fast to calculate

• Managers can easily understand the results

• It helps to estimate how fast the initial investment can be recovered

Answer explanation

A disadvantage of the payback period as a method of investment appraisal is that ignores the overall profitability of an investment. Ignoring the overall profitability of an investment is an advantage of the average rate of return. All other options are all advantages of the payback period.

What is the correct formula for calculating the payback period?

• Annual cash flow from investment ÷ initial investment cost

• Gross profit ÷ total sales revenue × 100

• Initial investment cost ÷ annual cash flow from investment

• Annual cash flow from investment – original cost of investment

What is meant by the payback period?

• The period over which the investment is expected to earn profit

• The amount of time required to prosecute a fraudulent customer

• The length of time for an investment project to repay its initial cost outlay

• The total cash proceeds from an investment project

Investment refers to the __ expenditure of a business.

• capital

• revenue

Definition: The sum of an investment project’s net cash flows for a particular year plus the net cash flows of all previous years.

• Net Present Vale

• Accounting rate of return (ARR)

• Cumulative net cash flow

• Principal