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IAI Actuarial Core Principles · Business Finance · Cost of capital and evaluating investment projects

Which of the following is a recognised limitation of the simple payback period as a project appraisal method?

Simple payback ignores all cash flows that occur after the payback date. A project with large later inflows can therefore be rejected wrongly. The method uses undiscounted cash flows and needs no cost of capital, so the other statements do not describe its limitation.

  1. AIt ignores cash flows arising after the payback dateCorrect
  2. BIt cannot be calculated when cash flows are uneven
  3. CIt requires an estimate of the cost of capital
  4. DIt discounts early cash flows too heavily
  5. It uses accounting profits rather than cash flows

Explanation

Simple payback measures only how long it takes to recover the initial outlay. Cash flows after that date are ignored, so a project with large later inflows may be rejected. It does not need a discount rate and it uses cash flows, so the other options are incorrect.

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