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CHAPTER 9
NET PRESENT VALUE AND OTHER
INVESTMENT CRITERIA
Answers to Concepts Review and Critical Thinking Questions
1.
A payback period less than the project’s life means that the NPV is positive for a zero discount rate, but
nothing more definitive can be said. For discount rates greater than zero, the payback period will still be
less than the project’s life, but the NPV may be positive, zero, or negative, depending on whether the
discount rate is less than, equal to, or greater than the IRR. The discounted payback includes the effect
of the relevant discount rate. If a project’s discounted payback period is less than the project’s life, it
must be the case that NPV is positive.
2.
If a project has a positive NPV for a certain discount rate, then it will also have a positive NPV for a
zero discount rate; thus, the payback period must be less than the project life. Since discounted payback
is calculated at the same discount rate as is NPV, if NPV is positive, the discounted payback period
must be less than the project’s life. If NPV is positive, then the present value of future cash inflows is
greater than the initial investment cost; thus PI must be greater than 1. If NPV is positive for a certain
discount rate R, then it will be zero for some larger discount rate R*; thus the IRR must be greater than
the required return.
3.
a.
Payback period is simply the accounting breakeven point of a series of cash flows. To actually
compute the payback period, it is assumed that any cash flow occurring during a given period is
realized continuously throughout the period, and not at a single point in time. The payback is then
the point in time for the series of cash flows when the initial cash outlays are fully recovered.
Given some predetermined cutoff for the payback period, the decision rule is to accept projects that
payback before this cutoff, and reject projects that take longer to payback.
b.
The worst problem associated with payback period is that it ignores the time value of money. In
addition, the selection of a hurdle point for payback period is an arbitrary exercise that lacks any
steadfast rule or method. The payback period is biased towards shortterm projects; it fully ignores
any cash flows that occur after the cutoff point.
c.
Despite its shortcomings, payback is often used because (1) the analysis is straightforward and
simple and (2) accounting numbers and estimates are readily available. Materiality considerations
often warrant a payback analysis as sufficient; maintenance projects are another example where the
detailed analysis of other methods is often not needed. Since payback is biased towards liquidity, it
may be a useful and appropriate analysis method for shortterm projects where cash management
is most important.
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 Summer '10
 D
 Economics

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