COST ACCOUNTING
CAPITAL BUDGETING
Question
[CLICK ON ANY CHOICE TO KNOW THE RIGHT ANSWER]


Provides an indication of a project’s risk and liquidity


Easy to calculate and understand


Ignores the TVM


Ignores CFs occurring after the payback period

Detailed explanation1: Payback ignores the time value of money. Payback ignores cash flows beyond the payback period, thereby ignoring the “profitability” of a project. To calculate a more exact payback period: Payback Period = Amount to be Invested/Estimated Annual Net Cash Flow.
Detailed explanation2: The two major weaknesses of the payback method are: • the time value of money is not considered; • the cash flows after the investment is recovered are not considered. the time value of money is not considered; the cash flows after the investment is recovered are not considered.
Detailed explanation3: Answer and Explanation: The statement is true. The calculation of payback period takes into account all the cash flows of a project, but it does not discount them to the present value (in other words, it does not consider the time value of money).
Detailed explanation4: Limitations of Payback Period Analysis The first is that it fails to take into account the time value of money (TVM) and adjust the cash inflows accordingly. The TVM is the idea that the value of cash today will be worth more than in the future because of the present day’s earning potential.
Detailed explanation5: Note that the payback method has two significant weaknesses. First, it does not consider the time value of money. Second, it only considers the cash inflows until the investment cash outflows are recovered; cash inflows after the payback period are not part of the analysis.