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

Vellmar Ltd's board prefers payback as its main appraisal technique for a long-term technology project whose largest cash flows arise in years 6 to 10. Which is the most significant weakness of relying on payback here?

The key weakness is that payback ignores cash flows arising after the payback period. Since this project's largest inflows come in years 6 to 10, payback could reject a project that would add shareholder value, as it also ignores the time value of money.

  1. AIt ignores cash flows after the payback period, so it may reject a value-adding projectCorrect
  2. BIt cannot be calculated when cash flows are uneven
  3. CIt uses accounting profit rather than cash flows
  4. DIt requires an estimate of the cost of capital

Explanation

Payback ignores all cash flows beyond the cut-off period, so a project whose benefits arrive late may be rejected even though it has a positive NPV. Payback can be calculated with uneven flows and uses cash, not profit. Simple payback does not need a cost of capital, which is a further weakness rather than a requirement.

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