Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true?
a. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV).
b. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV).
c. The firm will accept too many projects in all economic states because a 4-year payback is too low.
d. The firm will accept too few projects in all economic states because a 4-year payback is too high.
e. If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak.
Answer: the correct answer is b. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV).
The payback method ignores the time value of money and cash flows beyond the payback period, which can lead to incorrect decisions about accepting or rejecting projects. When a firm uses a fixed payback period, it may accept short-term projects with lower NPV and reject long-term projects with higher NPV, leading to a suboptimal decision.
In this case, if the firm relies exclusively on the payback method and sets a 4-year payback period, it will likely accept too many long-term projects and reject too many short-term projects that have a higher NPV. This is because some short-term projects may pay back the initial investment within 4 years, but have a negative NPV over their entire life. On the other hand, some long-term projects may take more than 4 years to pay back the initial investment, but have a positive NPV over their entire life.
Therefore, option (b) is the correct answer.