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- 5 Marks
Question
In investment appraisal, many methods are available for use by finance and project professionals. One of these methods is the Payback period, but stakeholders have often raised questions on the usefulness of this method due to a number of limitations inherent in the use of the method.
Required:
Explain FOUR (4) limitations of using the Payback period method in investment appraisals. (5 marks)
Answer
The limitations of using the Payback period method in investment appraisals include:
- Ignores the time value of money: The Payback period method does not consider the time value of money, which means it treats all cash flows as if they occur at the same time. This can lead to misleading conclusions about the value of future cash flows.
- Does not measure profitability: The method focuses only on how quickly an investment can recoup its initial cost, without considering the overall profitability of the project. Projects that generate higher returns in the long run may be overlooked if they have a longer payback period.
- Arbitrary choice of period: The decision on what constitutes an acceptable payback period is often arbitrary and may not align with the strategic objectives of the company or the economic realities of the project.
- Ignores cash flows after the payback period: The method does not take into account any cash flows that occur after the payback period. As a result, it may favor projects with quick returns but lower total returns, ignoring projects that could be more profitable in the long term.
(Marks allocation: 4 points @ 1.25 marks each = 5 marks)
- Tags: Investment Appraisal, Investment decision-making, Limitations, Payback Period
- Level: Level 2
- Topic: Introduction to Investment Appraisal
- Series: APR 2022
- Uploader: Theophilus