Explain TWO (2) advantages and TWO (2) disadvantages of the payback method of investment appraisal and show how it compares to the discounted cash flow method. (4 marks)
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Advantages of Payback Method and how it compares with Discounted Cash flow
- It is Simple Payback is easy to calculate. Payback method looks at the number of years which make it simple and easy to understand.
- Offers Quick Evaluation Determining which projects can generate fast returns is important to companies especially those with limited resources. Managers of such companies use this method to make a quick evaluation regarding projects with the small investment and short payback period.
- It shows the importance of considering liquidity when making investment decisions.
- It offers the shortest approach to calculating capital expenditure.
(Any 2 points well explained for 2 marks)
Disadvantages of the Payback Method and how it compares with Discounted Cash flow
- Ignores the time value of money: The most serious disadvantage of the payback method is that it does not consider the time value of money. Cash flows received during the early years of a project get a higher weight than cash flows received in later years. Two projects could have the same payback period, but one project generates more cash flow in the early years, whereas the other project has higher cash flows in the later years. In this instance, the payback method does not provide a clear determination as to which project to select.
- Neglects cash flows received after payback period: For some projects, the largest cash flows may not occur until after the payback period has ended. These projects could have higher returns on investment and may be preferable to projects that have shorter payback times.
- Ignores a project’s profitability: Just because a project has a short payback period does not mean that it is profitable. If the cash flows end at the payback period or are drastically reduced, a project might never return a profit and therefore, it would be an unwise investment.
- Does not consider a project’s return on investment: Some companies require capital investments to exceed a certain hurdle of rate of return; otherwise the project is declined. The payback method does not consider a project’s rate of return.
(Any 2 points well explained for 2 marks)