Question

Will the payback period from using the discounted payback period approach be longer or shorter than using undiscounted payback period approach (to capital budgeting)?

1) Longer
2) Shorter

Answer 1

The payback period from using the discounted payback period approach be 1. Longer than using undiscounted payback period approach (to capital budgeting)

Explanation:

The payback period from using the discounted payback period approach is generally longer than that from using the undiscounted payback period approach. The discounted payback period considers the time value of money by discounting future cash flows back to their present value. This approach accounts for the opportunity cost of tying up capital over time. As a result, since the discounted payback period takes into consideration the present value of cash flows, it tends to be longer than the undiscounted payback period.

To illustrate, consider an investment project with future cash flows of $100 each year for three years. If we use the undiscounted payback period approach, we would simply add up the cash flows until the initial investment is recovered. However, the discounted payback period would involve discounting these future cash flows back to their present value and then calculating the time it takes for the discounted cash flows to recover the initial investment. Due to the discounting process, the discounted payback period is likely to be longer than the undiscounted payback period.

In capital budgeting decisions, understanding the time value of money is crucial. The discounted payback period provides a more accurate measure of the investment's profitability by recognizing that a dollar received in the future is worth less than a dollar received today. Therefore, it is a more sophisticated approach that reflects the economic reality of the time value of money.

Answer 2

The payback period using the discounted payback period approach is generally longer than using the undiscounted method because it accounts for the time value of money by discounting future cash flows.

The correct option is 1.

Step-by-step explanation:

When comparing the discounted payback period approach to the undiscounted payback period approach in capital budgeting, the payback period is generally longer using the discounted method.

This is because the discounted payback period takes the time value of money into account by discounting future cash flows, which makes them smaller in present value terms, hence it typically takes a longer period to recover the initial investment.

On the other hand, the simple or undiscounted payback period does not consider the time value of money and only calculates the time it will take for the initial investment to be repaid by the nominal cash flows, without discounting them, which tends to result in a shorter payback period.

The correct option is 1.