What are the limitations of the Payback Rule?

Question

BlackTom AI · Accepted Answer

The Payback Rule measures how long it takes for cumulative, undiscounted cash inflows to equal the initial investment — you add nominal cash receipts year by year until the original outlay is recovered.

1) Relevant concepts:
- Payback period: the number of years to recoup the initial cost using nominal cash flows.
- Time value of money (TVM): a dollar today is worth more than a dollar tomorrow; proper valuation discounts future cash flows.
- Discounted payback and NPV: methods that account for TVM and overall project profitability.

2) Step‑by‑step reasoning:
- Under the Payback Rule you sum raw cash flows (no discounting) until the initial investment is recovered. Example: initial outlay $100; Year1 = $60, Year2 = $50. Cumulative after Year1 = $60; after Year2 = $110 → payback occurs during Year2. The rule treats those dollar amounts at face value.
- Because it uses undiscounted sums, it does not adjust later cash flows downward for delayed receipt. If a firm’s required return is 10%, Year2’s $50 has a present value of $50/(1.10) = $45.45; payback ignores this difference.

3) Intermediate calculation example (illustrating TVM omission):
- PV of Year2 $50 at 10% = 50 / 1.10 = 45.45. Undiscounted cumulative = 110, discounted cumulative = 60 + 45.45 = 105.45. The payback rule would treat both dollars equally, so it overstates value of delayed cash.

4) Why the correct answer is correct:
- The statement “It ignores the time value of money.” precisely captures the fundamental limitation: payback uses undiscounted cash flows and therefore misjudges projects where timing of receipts matters.

5) Why other options are incorrect:
- “It favors long-term projects.” — false; it favors short‑term projects that recover costs quickly.
- “It accounts for cash flows only after the specified period.” — reversed/incorrect: it ignores cash flows after the payback period.
- “It relies on the expected cost of capital…” — incorrect: payback does not use a discount rate or cost of capital.

Conclusion: The correct limitation is that the Payback Rule ignores the time value of money, matching the provided answer.

What are the limitations of the Payback Rule?单项选择题

类似问题

Four of the following statements are truly disadvantages of the regular payback method, but one is not a disadvantage of this method. Which one is NOT a disadvantage of the payback method?

With respect to the Payback Rule, the following statements are TRUE:

You own a bond that pays $64 in interest annually. The face value is $1,000 and the current market price is $1,021.61. The bond matures in 11 years. What is the yield to maturity?

Which of the following statements is CORRECT?

It will cost $9,600 to acquire an ice cream cart that is expected to produce cash inflows of $3,600 a year for three years. After the three years, the cart is expected to be worthless. What is the payback period?

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