Describe briefly the limitations of the simple payback period as an evaluation criterion and why this...

Describe briefly the limitations of the simple payback period as an evaluation criterion and why this can disadvantage renewable energy technologies compared to conventional fossil fuel power supply.

Expert Solution

The first limitation is that simple payback period does not consider the discounting factor to the cash flows. It avoids the risk and inflation associated with the cash inflows taking place in the future. The second limitation is the lack of focus upon the rate of return as simple payback period only considers the time taken up to recover the investment. But, investors want to know the return upon the investment that is not explained by the simple payback period. The third limitation is that this method does not help in identifying the size of wealth that can be created after pursuing the project. But, it is the ultimate objective of the firm.

This method become disadvantageous for the renewable energy projects as these projects incur relatively higher capital cost that will be recovered in the long term. Further, the value of cash flows will be high as the project continues in long term. But, the value of cash inflows will be lower if adjusted against inflation. Here, simple payback method does not consider it and evaluation of such projects are more error prone due to non-consideration of inflation, uncertainties and other risk considerations of the future. So, the simple payback method is not good for such projects.

Rahul Sunny answered 2 years ago

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