A disadvantage of using the payback period to compare investment alternatives is that:
A) It ignores cash flows beyond the payback period.
B) It includes the time value of money.
C) It cannot be used when cash flows are not uniform.
D) It cannot be used if a company records depreciation.
E) It cannot be used to compare investments with different initial investments.
The Correct Answer for the given question is Option A) It ignores cash flows beyond the payback period.
A disadvantage of using the payback period to compare investment alternatives is that it ignores cash flows beyond the payback period. The biggest problem with the payback period method is that it only looks at cash flow for a certain period of time. It is fine for businesses to want to see how quickly they can break even on their investment, but this is not always the case. The return on investment, after the initial investment is paid back, will not be a factor in these scores, and that can be very short-sighted.
There is no consideration of cash flows that occur beyond the payback period. The amount of cash inflows that are necessary to recover the cash outflows is all that is considered. This can result in picking a project that generates a high return in the early years, but a low return later on.The vast majority of capital expenditures have a long life span and continue to generate cash flow long after the payback period is over. The payback period focuses on short term profitability, which may cause a valuable project to be overlooked if it is the only consideration.
Try these Payback Period FAQs
How does depreciation affect the calculation of a project’s payback period?
a) Cost of investment/Annual net cash flow
b) Total net cash flow/Cost of investment
c) Cost of investment/Total net cash flow
d) Annual net cash flow/Cost of investment
e) Total net cash flow/Annual net cash flow
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