You asked: What are the disadvantages of using the payback period to evaluate an investment?

What are the disadvantages of using the payback period?

Disadvantages of the Payback Method

Ignores the time value of money: The most serious disadvantage of the payback method is that it does not consider the time value of money. Cash flows received during the early years of a project get a higher weight than cash flows received in later years.

What weaknesses are commonly associated with the use of the payback period to evaluate a proposed investment?

The weaknesses of using the payback period are (1) no explicit consideration of shareholders’ wealth, (2) failure to take fully into account the time value of money, and (3) failure to consider returns beyond the payback period and hence overall profitability of projects.

How can payback period be used to evaluate potential projects?

Figuring out the payback period is simple. It is the cost of the investment divided by the average annual cash flow. The shorter the payback, the more desirable the investment. Conversely, the longer the payback, the less desirable it is.

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What are the advantages of using the payback period to evaluate cash flows?

The payback period is an effective measure of investment risk. The project with a shortest payback period has less risk than with the project with longer payback period. The payback period is often used when liquidity is an important criteria to choose a project.

What is the major criticism of the payback and simple rate of return methods of making capital budgeting decisions?

A major criticism of paybacks and the simple return method is that both ways eliminates the time value of money. The payback period does not consider the effect of the time value of money in capital budgeting process.

What are the advantages and disadvantages of the net present value method?

Advantages and disadvantages of NPV

NPV Advantages NPV Disadvantages
Incorporates time value of money. Accuracy depends on quality of inputs.
Simple way to determine if a project delivers value. Not useful for comparing projects of different sizes, as the largest projects typically generate highest returns.

Why is the payback period often criticized?

A major criticism of the payback period method is that it ignores the “time value of money,” the principle that describes how the value of a dollar changes over time. A project that costs $100,000 upfront and generates $10,000 in positive cash flow per year has a payback period of 10 years.

What are the advantages and disadvantages of accounting rate of return?

What are the advantages and disadvantages of using the accounting rate of return?

Advantages
2 It is easy to calculate and understand the payback pattern over the economic life of the project
3 It shows the profitability of an investment and helps to measure the current performance of the project
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