What are the two primary drawbacks to the payback period method?
a. difficult to calculate; ignores time value of money
b. difficult to calculate; only works for long projects (e.g., 5 years or more)
c. ignores time value of money; ignores cash flows after payback is reached
d. difficult to calculate; ignores cash flows after payback is reached
The payback period method is a simplified method of calculating the time required to fully recover the initial investment made in any initiative. When there are several options available for making an investment, usually the one with the smallest payback period is considered as the initial investment is being recovered in the smallest duration of time. The formula to calculate the payback period is: payback period = (initial investment)/(annual cash inflows)
This method does not take into account the reduction in the value of money, also known as time value of money. A cash inflow received earlier is worth more than that received later. This is due to inflation as well opportunity cost in the form of interest not being earned. The payback method also does not consider inflows after the payback is complete. In most projects this is a substantial amount and something that actually decides how profitable the investment is.
The correct answer is option C.