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CA Intermediate · Financial Management and Strategic Management · Investment Decisions

Which of the following is a recognised limitation of the Payback Period method of evaluating investment proposals?

The payback period method ignores cash flows that occur after the payback point. It only measures how quickly the initial investment is recovered, without considering later profitability, and the simple version also ignores the time value of money.

  1. AIt ignores cash flows occurring after the payback pointCorrect
  2. BIt requires the cost of capital to be known
  3. CIt discounts all cash flows to present value
  4. DIt uses accounting profit rather than cash flow

Explanation

Payback only measures the time needed to recover the initial outlay, so cash flows arising after that point are not considered. Simple payback does not use the cost of capital or discounting, so those options describe other methods. It is based on cash flows, not accounting profit (that is ARR).

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