A project with a shorter payback period

Question

BlackTom AI · Accepted Answer

Payback period measures how long it takes for a project’s cumulative cash inflows to equal the initial investment. A shorter payback means the investor recovers capital sooner, which reduces exposure to future uncertainty and liquidity risk.

1) Relevant knowledge points and concepts
- Payback period definition: time until cumulative undiscounted (or sometimes discounted) cash flows equal initial outlay.
- Risk implication: faster recovery lowers the time capital is at risk from operational, market, or technological failures.
- Limitations: payback ignores cash flows after the cutoff and (when undiscounted) ignores time value of money. NPV and profitability measures capture total value and returns, respectively.

2) Step-by-step reasoning
- If Project A returns the invested amount in 2 years and Project B in 6 years, Project A’s owner is exposed to only 2 years of uncertainty versus 6 years for B.
- Earlier recovery increases flexibility (funds can be redeployed sooner) and reduces chance of permanent loss if later cash flows fail to materialize.
- Thus, a shorter payback generally signals lower investment risk and better liquidity.

3) Intermediate illustration
- Example: Initial investment $1,000. Project A: Year1 $600, Year2 $400 → payback = 2 years. Project B: Year1 $100, Years2–6 gradually total $1,000 → payback = 6 years. Even if B later produces larger total cash flows, A exposes the investor to fewer years of uncertainty.

4) Why the correct answer is correct
- The phrase “generally indicates” is important: shorter payback tends to reduce exposure to risk and improves liquidity. It does not guarantee superiority on other performance metrics.

5) Why other options are incorrect
- “Always should be selected over longer payback projects”: false — a longer-payback project can have much higher NPV or strategic value, making it preferable.
- “Always has a higher net present value”: false — NPV depends on total discounted cash flows; a short payback project can have lower NPV.
- “Always has higher profitability”: false — profitability ratios (e.g., ROI, IRR) depend on magnitudes and timing of all cash flows, not just payback.

6) Conclusion
A shorter payback period generally indicates lower investment risk. This matches the provided correct answer: generally indicates lower investment risk.

A project with a shorter payback period单项选择题

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