Access the main shortcomings of the payback method.

Expert Solution

* It ignores the time value of money :-- The payback method does not use discounted cash flows, and so it ignores the time value of money.

* It encourages establishing a short payback period : -- Whether a project is acceptable or unacceptable is totally dependent on the length of the payback period selected, and that is a purely subjective, arbitrary choice. Since the payback method does not consider the time value of money, a project with a short payback period might actually have a negative NPV.

* It offers no consideration of cash flows beyond the expiration of the payback period :--- Cash flows after the payback point has been reached do not count for anything in the payback analysis. If two projects are being compared and they both reach their payback point in 3years time, Project A may have significant cash flows following that payback point whereas Project B’s cash flows may drop off very quickly after that point. If management looks only at the payback periods for both projects, it could miss recognizing the difference in the longer-term profitability of the two projects.

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