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The statement 2 and statement 3 here are not correct, but I can’t tell exactly why is this. Please help me understand it, thank you so much!
The ROCE is an accounting measure whereas the cost of equity is not. Also the cost of equity relates to only one part of the capital employed because there is also debt borrowing.
The shorter the payback period, the less risk there is of the project not paying for itself. I explain this in my free lectures – it is the main reason for using the payback period as one method of appraisal.
I understand that the shorter the payback period the less risk there is. Then according to this, I think rickier projects are with longer payback periods (which is the statement 3 here)?
Because the directors require the payback period to be used (as per the stem of the question) then if they are going to do that they need to allow a longer period if the project is more risky.
yeah… allowing a longer period for riskier projects – this is exactly what the statement 3 said! But according to the answer, it is wrong.
Sorry, I am not being clear enough and ignore what I wrote about the directors – my original reply was correct.
When forecasting the future cash flows then the further into the future we forecast the more they become little more than guesses.
It is always the forecasts for the earlier years that we will be more confident about and therefore the shorter the payback period the more sure we will be that the project will pay for itself. The more risky the project then the shorter the period over which we will feel at all confident of our estimates and therefore the short the payback period has to be to have any confidence in the project paying for itself.
Aaaa, so for either ricky or not, we should evaluate the project with short payback period 🙂 got it, thank you so much sir!
You are welcome.