Analyse the problem and give detailed steps to solve it.
Learning Goal: I’m working on a management question and need an explanation and answer to help me learn.
Antar is planning to build a new factory. The factory will cost 5 million to build and will afterwards produce cash flows of 1 million per year for 15 years, with the first cash flow in one year. Your cost of capital is 10% and your company’s preferred payback period is seven years or less.
- • • •
Should you build the new factory based on the payback rule? Should you build the factory based on NPV rule?
Now assume that the cost of your capital is 20 %. Should you build the new factory based on the payback rule? Should you build the factory based on NPV rule?
What weakness of payback rule does the example highlight? Discuss more generally this and other potential weaknesses of the payback rule.
There is empirical evidence that companies still use payback rule nowadays when making investment decisions. Based on your reading of academic literature and other course materials, discuss potential reasons for this.
