Importance of Payback Method in Capital Budgeting Decision

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School of Management

Blekinge Institute of Technology

THE IMPORTANCE OF THE PAYBACK METHOD IN CAPITAL BUDGETING DECISION.

By

Alaba Femi, AWOMEWE & Oludele Olawale, OGUNDELE

Supervisor: Anders Hederstierna

Thesis for the Master’s degree in Business Administration Fall/Spring 2008

THE IMPORTANCE OF THE PAYBACK METHOD IN CAPITAL BUDGETING DECISION.

By

Alaba Femi, AWOMEWE & Oludele Olawale, OGUNDELE

A thesis submitted in partial fulfillment of the requirements for the degree of MBA (Master of Business Administration)

Blekinge Institute of Technology

2008

Supervisor Anders Hederstierna

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Abstract Title: The importance of the Payback method in Capital budgeting decision.

Authors: Alaba Femi, Awomewe and Oludele Olawale, Ogundele

Supervisor: Anders Hederstierna

Department: School of Management, Blekinge Institute of Technology

Course: Master’s thesis in business administration, 15 credits (ECTS).

Background and Problem Discussion: The capital budgeting decision has been a very typical issue in the sustenance of a company. Several companies have lost their identity or liquidated due to wrong capital budgeting decision they made at one particular time or the other. Based on these prevalent problems in industries and the effect of globalisation on industries, it is important to use effective method to analyse investment before decision is made. Capital budgeting is extremely important because the decision made involve the direction and opportunity for future growth of the organisation. One of the traditional methods commonly used for capital investment appraisal by some organizations is the payback method, although this method has been criticized by academicians that it does not include the future cash flow and do not measure profitability. The wide acceptance of this method by practicing managers, has called for investigation as why is the method is still popularly used in organizations. In this thesis work, we will examine the reasons major decision makers in organizations still use this method despite its critics’ objections. Could the reason be traced to

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the simplicity of this method in capital budgeting than other investment appraisal method or could it be other reasons? Purpose: The specific aim of this thesis is to investigate the importance of the use of the payback method in making capital budget decisions in relation to other appraisal techniques used for capital budgeting decision in organizations. We will also examine the importance of the payback method in relation to simplicity, manager incentive compensation and the size of the company. Method: In this thesis, the method used are the theories on payback period as it affects decision making in the organization and past research work on methods which companies used in appraising investment are used as secondary data in order to have a basic insight into the importance of the payback method in capital budgeting.

Theory: The theory section looks at the capital budgeting decision, the methods that are often used in the capital budgeting decision showing the advantages and disadvantages that are associated which each of the method. Finally, the payback method was look at in detailed and the developments in the payback period.

Research Questions: In this thesis, we intend to try to answer the following questions:  Why do companies seem to prefer the use of the payback method when they evaluate investment opportunities?   Is the payback method a simplified options approach? Does the payback method chosen by companies have anything to do with financial flexibility related to the pecking order theory or anything to do with decentralized organizations with departmental capital budgets?  How does the payback method affect the evaluation of managers? iv



Is the use of the payback period related to the size of the company?

Analysis: Various research works that have been done on the payback...
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