Skip to content

ACCA Strategic Professional · Strategic Business Leader · Financial analysis and decision-making techniques

Marlow Pharma is considering a project costing $300,000 now. It is expected to generate net cash inflows of $120,000 at the end of each of years 1 to 4. Cash inflows arise evenly across each year. The board uses a payback cut-off of 3 years. Which statement is correct about the simple payback result and its main limitation?

Payback is 2.5 years: $240,000 is recovered by the end of year 2 and the remaining $60,000 is half of year 3's $120,000 inflow. The project meets the 3-year cut-off, but payback ignores the time value of money and cash flows after the payback point.

  1. APayback is 2.5 years, so it is accepted, but it ignores the time value of money and cash flows after paybackCorrect
  2. BPayback is 2.5 years, so it is accepted, and it is therefore reliable because it considers all cash flows
  3. CPayback is 3.0 years, so it is rejected, since the project must be completed within the cut-off
  4. DPayback is 3.5 years, so it is rejected, because the final year's cash flow is excluded

Explanation

Cumulative inflows are $120,000, $240,000 and $360,000 after years 1, 2 and 3. The remaining $60,000 needed after year 2 is half of year 3's $120,000, giving 2.5 years. This is within the 3-year cut-off. Payback's key weaknesses are that it ignores discounting and cash flows after the payback point.

Did you get it right without looking?

One question tells you little. A timed set on Financial analysis and decision-making techniques shows your real accuracy, how long you take and where you lose marks.

Practise Financial analysis and decision-making techniquesFree diagnostic mock

More Financial analysis and decision-making techniques questions