Final answer:
The payback period approach is useful in ranking capital projects when considering the time it takes to recoup the initial investment. It helps businesses compare and prioritize investments based on how quickly they generate returns.
Step-by-step explanation:
The payback period approach is useful in ranking capital projects when the decision-making process takes into consideration the time it will take to recoup the initial investment. This approach is commonly used in industries where shorter payback periods are preferred, such as manufacturing or technology. By calculating the payback period for different projects, businesses can compare and prioritize investments based on how quickly they will generate returns.
For example, let's say Company A is considering two capital projects: Project X and Project Y. Project X requires an initial investment of $100,000 and is expected to generate annual savings of $25,000. Project Y requires an initial investment of $150,000 and is expected to generate annual savings of $30,000. The payback period for Project X would be 4 years ($100,000 divided by $25,000), while the payback period for Project Y would be 5 years ($150,000 divided by $30,000). Based on the payback period, Company A may choose to prioritize Project X over Project Y, as it has a shorter payback period.