Hedge Funds and Leverage
Leverage is one of the defining features of any hedge fund. Therefore hedge funds have gained expertise in the creation and utilization of leverage. Not only do they use traditional means like equity and fixed income leverage but they also use create leverage with the help of futures, options and swaps. In this article, we […]
How Triparty Repo Works?
In the previous article, we have already learned about the repo market. We learned about how the repo market is one of the most important segments of the money market. We also learned about the large volumes of transactions that take place in the repo market. We already know that about $2 trillion to $4 […]
The Wells Fargo Auto Insurance Scandal
Wells Fargo is one of the largest banks in the United States. However, of late, it has also become one of the most infamous banks. A couple of years back Wells Fargo was in the news since its sales executives opened up fake accounts without the knowledge of the customers simply to meet the sales […]
Understanding Tax Terminology: Tax Base
Many students often find tax policy confusing. This is probably because it uses complex terms. The tax base is one such term that is often used in tax literature. The meaning of this term is often not completely understood by tax students. This creates further confusion. In this article, we will clarify the meaning of […]
External Causes of Organization Decline
Many theorists believe that organizational decay is caused by external factors. In fact, some have gone far enough to suggest the various stages in which this decline happens. However, the exact external causes are often difficult to understand. In this article, we will have a look at some of the most prominent causes of organizational […]
We have earlier discussed the fact that Net present Value (NPV) is considered to be the gold standard when it comes to financial decision making. If a project has an NPV greater than zero then it is supposed to be a financially viable project and the firm must invest its resources towards that project, if not the project should be rejected.
But NPV is not the only metric that we can use to come to this decision regarding accepting or rejecting a project. Payback period is another such metric. In this article we will discuss about the conceptual foundation of payback period and then we shall see its drawbacks.
Payback period basically pays attention to the speed at which the initial investment made in a project will be recovered by subsequent cash flows. The project which helps recoup the investment the fastest is considered to be the best project and that is the project that the firm must dedicate its resources to.
Example:
Let’s say that there are 2 projects A and B. Both require an equal outlay of $2000. Project A pays back $1500 in year 1, $500 in year 2 and $500 in year 3. Project B on the other hand pays $750 for 4 consecutive years.
So, now in this case if we were to use the payback period rule. We could consider the period in which the initial $2000 investment is recovered. In case of Project A, we recover it in 2 years whereas in case of Project B it requires 3 years. So according to the payback rule, Project A is better than Project B and the company must clearly devote its finite resources to Project A before it decides whether or not to undertake Project B.
Now, this decision could be wrong because of a couple of reasons:
To overcome the second limitation of ignoring the time value of money, a modified measure of payback period called the discounted payback period is often used. This measure still does not overcome the fact that payback period does not account for the cash flows after the initial investment has been recouped. This is the reason why payback period is not a perfect metric and why NPV leads to better decisions.
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