Payback method

  1. The payback method has flaws, as you know from the readings. Why then do managers use the payback
    method. Keep in mind that it’s not because they are lazy or uneducated. Those in the Finance Departments all
    have extensive training in Finance and Accounting. No, there is a reason above and beyond the fact that it is
    easy to use. Think of which industries need to get a quick return on their investments, as the fashion industry,
    and why payback would be useful for them.
  2. A firm has a $100 million capital budget. It is considering two projects that each cost $100 million. Project A
    has an IRR of 20%, an NPV of $9 million, and will be terminated after 1 year at a profit of $20 million, resulting
    in an immediate increase in EPS.
    Project B, which cannot be postponed, has an IRR of 30% and an NPV of $50 million. However, the firm’s
    short-run EPS will be reduced if it accepts Project B because no revenues will be generated for several years.
    Should the short-run effects on EPS influence the choice between the two projects? How might situations like
    this influence a firm’s decision to use payback?

Sample Solution