Capital Budgeting – Discounted Payback Period

Practice Question

Intro to Finance
Capital Budgeting
Discounted Payback Period
MCQs

The discounted payback period is longer than the simple payback period because:

A) The future cash flows are worth less.
B) The cut-off dates are different.
C) The cash outflows are worth more.
D) The PV of cash inflows are worth more.
E) Discounted payback is shorter than simple payback.
Answer +
Correct Answer: A) The future cash flows are worth less.
Explanation +

Definition of Variables:
- Discounted Payback Period: The time it takes for the present value of cash inflows to cover the initial investment, considering the time value of money.
- Simple Payback Period: The time it takes for nominal cash inflows to cover the initial investment, without considering time value of money.

Concept:
In the simple payback period, cash flows are not discounted, so future cash flows are considered at their nominal value.
In contrast, the discounted payback period adjusts each future cash flow for the time value of money, making them worth less.

Formulas:
- Simple Payback Period: \( \text{Initial Investment} \div \text{Annual Cash Inflows} \)
- Discounted Payback Period: Accumulate discounted cash inflows until they match the initial investment.

Because future cash flows are discounted and thus worth less, it takes longer to recover the initial investment, making the discounted payback period longer than the simple one.

Therefore, the correct answer is:
A) The future cash flows are worth less.