What is a significant disadvantage of the payback period?
a. does not properly consider the time value of money, b. Is complicated to explain, c. Increase firm risk, or d.Provides a measure if liquidity.
The significant disadvantage of the payback period is option a: it does not properly consider the time value of money. The payback period is a simple financial metric that calculates the length of time it takes to recoup the initial investment in a project or investment. It is calculated by dividing the initial cost of the investment by the cash inflows per year.
However, the payback period fails to take into account the concept of the time value of money, which states that money received or paid in the future is worth less than the same amount received or paid today. This means that cash inflows received in the future are not accounted for with the same value as those received immediately. By not considering the time value of money, the payback period fails to provide a comprehensive assessment of the profitability or value of an investment.
To properly evaluate the time value of money and account for the impact of cash flows over time, other financial metrics such as net present value (NPV) or internal rate of return (IRR) should be used. These metrics discount future cash flows to their present value, making them more accurate in assessing the true profitability or value of an investment.