Question

List and explain (in one to two sentences each) two problems with payback period that are not problems for NPV. Your explanation should include why these are problems (why we can't just ignore these issues).

Answer 1

The Payback period the number of years that a project takes to recover the initial investment. It is computed by dividing the initial investment by cash flow per year. A project with shorter payback period is considered to be profitable.

The payback period method suffers from the following disadvantages:

• Ignores Time value of money: The main problem with payback period is that, it fails to take into account the time value of money (TVM). It is a serious problem because, the value of money today will be worth more than in the future. Just taking the cash flows only, the investment decisions cannot be taken. Such decision will not be correct. If the project is profitable after considering the present value, the project can be accepted. Such problem will not be in Net Present Value method. Because it considers time value of money. Due to this drawback, Discounted Payback period method has been introduced, which considers time value of money.
• Ignores the cash inflows that occur after the payback period : payback period method does not consider the cash inflows that occur after the pay back period. If a project has a short payback period does not mean that it is profitable and vice versa. Initially the project may have less inflows and may have huge inflow in coming years. This fact is ignored in payback period method. This will lead to wrong investment decisions. It thus fails to compare the profitability with another projects. So this is a big problem of this method. But Net Present Value method considers all the inflows and such misleading decision will not happen in NPV method.