Question

a. Describe how the payback period is calculated and describe the information this measure provides about a sequence of cash flows. What is the payback criterion decision rule?

Answer 1

While taking a capital budgeting decision of source of fund, or the capital project to be chosen, we sometimes use Payback Period

It is defined as the tenure in which the cash flows will realize the cost of project, that is the period in which the entire cost will be paid back.

This provides the information regarding the time after which the project will be profitable, or the time at which it will reach break even.

The payback uses the criteria that if the payback period calculated is less than life of project it shall be accepted, in case it is equal to life of project then there will be no profit no loss, and in case payback is higher than life of project then there will be loss.