One of the disadvantages of the payback method is that it ignores time value of money. True False

Question:

One of the disadvantages of the payback method is that it ignores time value of money.

True

False

Payback Method:

The payback method is a method used to assess investment proposals in terms of the length of time necessary to recover investment's initial cost. According to this method, investment projects with shorter payback period are more attractive than those with longer payback period.

Answer and Explanation:

The statement is true.

The calculation of payback period takes into account all the cash flows of a project, but it does not discount them to the present value (in other words, it does not consider the time value of money). Discounting cash flows helps investors better see the actual value of future payments, since a specific amount today and the same amount in 5 years have different values now. Many other investment tools, such as net present value or internal rate of return, discount cash flows based on the given discount rate which positively affects the accuracy of results. The payback method does not take into account the time value of money which is definitely its disadvantage.


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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