If a company uses payback rule as investment what is the risk it faces and why?

Question

If a company uses the payback rule as an investment criertion, what is one of the risk it faces and why?

Answer 1

THE PAYBACK RULE
A. Defining the Rule
Payback period—the expected number of years required to recover the original investment.

Payback period = Years before full recovery + unrecovered cost at start of year/cash flow during year

Payback period rule—investment is acceptable if its calculated payback is less than some prespecified number of years.

B. Disadvantages
- No discounting involved
- Doesn't consider risk differences
- How to determine the cutoff point
- Bias for short-term investments

C. Advantages
- Simple to use (mostly by ignoring long-term)
- Bias for short-term promotes liquidity
- Can be adjusted for risk in some sense (altering the cutoff)