Net cash flow of project B is constant each year, so we can use formula below to calculate payback period (M W E Glautier and B Underdown, 2001):.
Payback period of project B = .
=.
=2.91 years.
III/ Which of these projects should be accepted?.
A project that has a payback period shorter than a maximum payback period expected by the business may be accepted (Peter Atrill and Eddie McLaney, 2009). Therefore, "which project should be accepted " depends on a maximum payback period AP Ltd decided. If a maximum period is 3 years, project B should be chosen because its payback period is less than 3 years, showing 2.91 years, whereas project A has a payback period of more than 3 years. On the other hand, if the business imposes a maximum payback is 4 years, both project A and B can be selected although it is better to choose project B that has a payback period shorter than project A.
Question C.
Payback is a simple method to decide to invest in an appropriate project. However, there are several disadvantages in using this technique as follows: It can not be useful when projects have the same payback period. Moreover, it only tends to choose short term projects than long term projects although long term project may be profitable than shorter projects. This is the most important weakness of payback method that "only measures cash flow but not measure profitability " (Dyson, 2007, p.424).
It does not mention the time value of money. This means it might not calculate exactly because £1 earned now is greater than £1 earned in the future (Meckin, 2007).
The total amount of the capital investment is ignored. As a result, the projects have shorter initial investment may have shorter payback period than the larger invested projects. Hence, the projects has shorter payback period are selected though the others may add more value to the business in the long term (Dyson, 2007).
