Question

Under which one of the following circumstances is the project accepted as worthwhile, keeping the principal non-discounting criteria ?
1. The payback period (PBP) > target period
2. The payback period (PBP) < target period
3. The payback period (PBP) = target period
4. The payback period (PBP) = 0

Answer 1

Correct Answer - Option 2 : The payback period (PBP) < target period

Explanation:

Non-discounting budgeting technique/non-discounting cash flow techniques

(a) Pay-back period

The payback period is the length of time taken by the company to recoup (or payback) the initial cost of producing the product, service, results of the project.

Payback period = Initial Investment/Annual Cash flow

• Shorter the pay-back period - accept the project.
• Longer the payback-Reject the project

 

Payback Period (PBP) is one of the simplest capital budgeting techniques. It calculates the number of years a project takes in recovering the initial investment based on the future expected cash inflows

(b) Accounting or average rate of return (ARR) method:

 \(ARR = \frac{Initial \ average \ profit \ after \ tax}{Annual \ Investment} \times100\)

• Highest ARR or ARR above the minimum expected rate of return - accept the project.
• The lower value of ARR or ARR is below a min. expected rate - reject the project.