Question

Which of the following statements indicate a disadvantage of using the discounted payback period for capital budgeting decisions? Choose all that apply. A. The discounted payback period does not take the project’s entire life into account. B. The discounted payback period does not take the time value of money into account. C. The discounted payback period is calculated using net income instead of cash flows.

Answer 1

Answer:

A. The discounted payback period does not take the project’s entire life into account.

Explanation:

The discounted payback period ignores the cash inflows from project after the payback period. A project  attractive, that has lower initial cash inflows but higher ending cash flows might not be selected . That is why this method does not take the project's entire life into account.

There are two methods of calculating payback period:

• Simple payback period and
• Discounted payback period.

Simple payback period is the number of years (time) required to recoup amount invested in a project from its net cash flows. A project with a shorter payback period is better than the one with longer payback period.   For example, if a company invests $9,000 in a new project, and the project produces positive cash flow of $3000 per year, then the payback period is 3.0 years ($9,000 initial investment ÷ $3,000 annual payback).

Discounted payback period method uses discounted cash flows while calculating the time an investment takes to pay back its initial capital outlay (cash outflow). This take care of disadvantages of simple payback period which ignores the time value of money. Discounted payback period accounts for the time value of money by discounting the cash inflows of the project for each period at a suitable discount rate.

The discounted payback period is more reliable than simple payback period because it accounts for time value of money. if a project has negative net present value it will not pay back the initial investment.

Answer 2

Answer:

A & B

a. The discounted payback period does not take the project’s entire life into account

b. The discounted payback period does not take the time value of money into account

Explanation: