One drawback of the payback method is that some cash flows may be ignored. True False Explain.

Question:

One drawback of the payback method is that some cash flows may be ignored.

True

False

Explain.

Payback Period:

The payback period of capital budgeting is applied to estimate the time that will lapse before an investor can recover the initial cost from the expected future cash flows. The payback period is simple to compute as it is a non-discounting method and will therefore not involve using formulas based on the time value of money principle.

Answer and Explanation:

One drawback of the payback method is that some cash flows may be ignored.

  • True

Explanation

Disadvantages of payback period method

  1. The method disregards the time value of money principle and cash flows used are at face value.
  2. The payback period method ignores the subsequent cash flows after the investor has been compensated the initial cost.

Under the payback period the investor's focus on the cash flows up to the period the initial cost is recovered. The cash flows that follow later on are not used for this calculation and this bias may affect the decision making process of an investor. Some projects will have a higher cash flow series at the initial years while others have significant cash flows past the payback period.

The payback period decision is made against the cut-off period. If a project payback period is within the set cut-off period the projects is accepted. However, if the significant cash flows are received past the cut off period, the investor may forego a good investment project.


Learn more about this topic:

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Payback Analysis: Formula & Example

from Introduction to Management: Help and Review

Chapter 16 / Lesson 12
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