Certified Financial Management Specialist Practice Exam

What does a longer discounted payback period suggest about an investment?

1. Lower profitability

2. Higher initial costs

3. Increased risk

4. Stable cash flow

The correct answer is: Increased risk

A longer discounted payback period indicates that it takes more time for an investment to generate enough discounted cash flows to recover its initial outlay. This extended period can imply that the investment carries increased risk, as it suggests the cash flows are either lower than anticipated or are occurring over a more extended time than initially expected. In financial terms, investments with a longer payback period are often perceived as less desirable because a longer wait to recover the initial costs exposes the investor to uncertainties over time. These uncertainties could stem from fluctuating market conditions, shifts in economic factors, or changes in the project's operational performance. Risk is inherently associated with the time value of money; the longer the period for payback, the more uncertain the projections become, which can lead to potential losses if the investment does not perform as expected. Thus, the correct inference from a longer discounted payback period is that it is signaling increased risk, as stakeholders have to rely on future cash flows that are uncertain for a more extended period.