Question 2 (b)
Limitations of the payback period
3 marks
- Time to write
- About 6 minutes
Question
Question 2 (b) · 3 marksExplain the limitations of Pay-Back Period (PBP).
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- ExplainEach point stated, then explained in a line or two.
Write it in this order
- 1 Ignores the time value of money 1 mark 2 min
- 2 Ignores flows after payback; not a measure of profitability 1 mark 2 min
- 3 Arbitrary cut-off; bias against long-term projects 1 mark 2 min
Try it first. About 6 minutes for 3 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
- It ignores the time value of money. A rupee recovered in year 3 is treated like a rupee in year 1; two projects with the same payback are rated equal even if one recovers most of its cost early and the other late.
- It ignores cash flows after the payback period. It looks only at how fast the outlay is recovered, not at the project's total profitability, so it cannot measure profitability.
- The cut-off period is arbitrary. It is chosen without objective basis and applied to all projects whatever their lives, so the firm tends to accept too many short-lived projects and too few long-lived ones.
1Rekha puts her savings into a juice cart—the jar on the counter starts empty.
Payback periodThe number of years a project takes to recover its initial investment from its cash inflows.
2Orange by orange, the jar fills back towards what the cart cost her.
Why it is a measure of liquidityHow quickly the funds locked in a project come back and can be put to other uses.
3The jar full, the counting stops—the measure never looks at all the selling still to come.
Why it is not a measure of profitabilityIt ignores the cash inflows after the payback period, however large.
Where the 3 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Ignores the time value of money | 1 |
| 2 | Ignores flows after payback; not a measure of profitability | 1 |
| 3 | Arbitrary cut-off; bias against long-term projects | 1 |
| Total | 3 |
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