I received the following question from Becker while studying for BEC:
Which of the following statements is true regarding the payback method?
a. It is a measure of how profitable one investment project is compared to another.
b. The salvage value of old equipment is ignored in the event of equipment replacement.
c. It does not consider the time value of money.
d. It is the time required to recover the investment and earn a profit.
Luckily, I answered the question correctly with option C, however, I also had a difficult time not selecting option B since salvage value is NOT considered in the computation of payback period. To justify not choosing option B, I thought of the salvage value of the old asset as a deduction from the initial investment of the new asset which SHOULD BE included in the computation of payback period.
Salvage value of old asset: $20,000
Purchase price of new asset: $170,000
Annual Cash Inflows: $50,000
($170,000-20,000)/$50,000 = 3 years
Does my assessment of the question seem to be correct or would you suggest a different explanation?