In statistics, you learn about Type I and Type II errors. A Type I error occurs when a statistical test rejects a hypothesis when the hypothesis is actually true. A Type II error occurs when a test fails to reject a hypothesis that is actually false. We can apply this type of thinking to capital budgeting. A Type I error occurs when a firm rejects an investment project that would actually enhance shareholder wealth. A Type II error occurs when a firm accepts a value-decreasing investment, an investment it should have rejected.
a. Describe the features of the payback rule that could lead to Type I errors.
b. Describe the features of the payback rule that could lead to Type II errors.
c. Which error do you think is more likely to occur when firms use payback analysis? Does your answer depend on the length of the cutoff payback period? You can assume a “typical” project cash flow stream, meaning that most cash outflows occur in the early years of a project.