A major criticism of the payback period method is that it ignores the “time value of money,” the principle that describes how the value of a dollar changes over time. A project that costs $100,000 upfront and generates $10,000 in positive cash flow per year has a payback period of 10 years.
Which of the following is a drawback of the payback period?
Disadvantages of the Payback Method Ignores the time value of money: The most serious disadvantage of the payback method is that it does not consider the time value of money. Cash flows received during the early years of a project get a higher weight than cash flows received in later years.
What is the payback period rule?
The payback period rule is one of the capital budgeting methods used by organizations. This method is used to determine the amount of time that is required for an investor to recover his cost of investment.
What are the disadvantages of using a payback period?
A: Limitations, or disadvantages, of using the payback period method in capital budgeting include the fact that it fails to take into account the time value of money and does not factor in the value of additional cash flows beyond the payback period.
How does the company calculate the payback period?
Some companies use a variation of the payback period method that accounts for the time value of money. In the “discounted payback method,” the company adjusts the value of the anticipated future cash flows so that they’re expressed in today’s dollars. It then calculates the payback period based on those adjusted values.
Why is Payback method important for cash poor firms?
It is therefore, a useful capital budgeting method for cash poor firms. A project with short payback period can improve the liquidity position of the business quickly. The payback period is important for the firms for which liquidity is very important.
How does the Payback method help a CFO?
Payback method helps in revealing the payback period of an investment. Payback period (PBP) is the time (number of years) it takes for the cash flows of incomes from a particular project to cover the initial investment. When a CFO faces a choice, he will prefer the project with the shortest payback period.
