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CFA Level I · CFA Level I Exam · Capital Investments and Capital Allocation

Which of the following is the most likely weakness of the payback period as a capital budgeting criterion?

The most likely weakness is that payback ignores cash flows occurring after the payback point. It only measures time to recover the initial investment, so it can reject profitable long-lived projects. Simple payback also ignores the time value of money, but it needs no cost of capital estimate.

  1. AIt ignores cash flows after the payback pointCorrect
  2. BIt requires an estimate of the cost of capital
  3. CIt cannot be calculated for projects with positive NPV

Explanation

Payback only measures how long it takes to recover the initial outlay, so cash flows after that point, which may be large, are disregarded. The simple payback does not need a discount rate, so the second option is wrong. Payback can be computed for positive-NPV projects, so the third is wrong.

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