Question

Which of the following is a limitation of the payback period method?

• A. It considers the time value of money
• B. It ignores cash flows beyond the payback period
• C. It is difficult to calculate
• D. It always matches the IRR results

Hint:

Always remember: the payback period method focuses only on the time to recover investment and ignores profits or losses after that point.

Answer 1

The Correct Option is B

The payback period method is a simple and widely used tool in capital budgeting. It measures the time required to recover the original investment from the cash inflows generated by the project.
However, this method has some significant limitations:
1. It ignores the time value of money: The method does not discount future cash flows. Hence, it treats money received in different years as having the same value, which is not economically accurate.
2. It ignores cash flows beyond the payback period: Once the initial investment is recovered, any additional cash inflows are disregarded in decision-making. This means a project that generates massive profits after the payback period may be undervalued or even rejected.
3. It does not provide a clear picture of overall profitability or risk: Since it only focuses on the recovery period, it gives no information about the total return on investment.
Among the given options, only option (2) directly states this critical limitation.
Option (1) is incorrect because the payback period method actually does not consider the time value of money.
Option (3) is incorrect — the method is simple and easy to calculate.
Option (4) is incorrect — it has no relation to Internal Rate of Return (IRR), and results usually do not match.
Thus, the most appropriate limitation listed is:
It ignores cash flows beyond the payback period.