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.

Question

Quizplus · Accepted Answer

Statement e is correct.In a weak economy,the interest rates and the WACC are likely to be low,and these conditions favor long-term projects.But the constant 4-year payback would not recognize this situation.

Suppose a Firm Relies Exclusively on the Payback Method When