Final answer:
The payback period method focuses only on how long it takes to recover an investment and ignores both long-term profitability and the time value of money, leading to potential underestimation of investment risk and return.
Step-by-step explanation:
The payback period as a capital budgeting evaluation method has some weaknesses. One of the main answer issues is that it mainly considers the time it takes for an investment to recoup its initial cost without taking into account the profitability beyond the payback period. This can lead to short-term thinking and does not address the long-term profitability or risks associated with an investment. Additionally, the payback period does not take the time value of money into account, meaning future cash flows are not discounted, which could lead to overvaluation of near-term savings and undervaluation of later profits.
Disadvantages of Payback Period
- Focuses solely on the time needed to recover investment
- Does not measure total profitability or return on investment
- Ignores cash flows received after the payback period
- Does not consider the time value of money
In contrast to other investment appraisal techniques, such as Net Present Value (NPV) or Internal Rate of Return (IRR), which consider both the time value of money and the profitability over the entire life of an investment, the payback period method has these pointed weaknesses.