Answer:
Step-by-step explanation:
1) It ignores the time value of money. (2) It ignores the cash flows that occur after the payback period. (3) Unlike the NPV, which tells us by how much the project should increase shareholder wealth, and the IRR, which tells us how much a project yields over the cost of capital, the payback merely tells us when we get out investment back. Discounted payback does consider the time value of money, but it still fails to consider cash flows after the payback period and it gives us no specific decision rule for acceptance; hence, it has 2 basic flaws. In spite of its deficiency, many firms today still calculate the discounted payback and give some weight to it when making capital budgeting decisions. However, payback is not generally used as the primary decision tool. Rather, it is used as a rough measure of a project’s liquidity and riskiness. I. As a separate project (Project P), the firm is considering sponsoring a pavilion at the upcoming World’s Fair. The pavilion would cost $800,000, and it is expected to result in $5 million of incremental cash inflows during its 1 year of operation. However, it would then take another year, and $5 million of costs, to demolish the site and return it to its original condition. Thus, Project P’s expected net cash flows look like this (in millions of dollars): 0 1 2 | | | -0.8 5.0 -5.0 The project is estimated to be of average risk, so its WACC is 10%.