The payback period (which tells the number of years needed to recover the amount of cash that was initially invested) has two limitations or drawbacks:
- The net incremental cash flows are usually not adjusted for the time value of money. This means that a net incremental cash inflow of $50,000 in the fourth year of an investment is deemed to have the same value or purchasing power as a $50,000 cash outflow that was part of the initial investment made four years earlier.
- The incremental cash flows received after the payback period are ignored. Let's illustrate what this means by using two hypothetical projects which are being considered as an investment:
- Project #187 has a payback period of 4 years. However, the amounts of the net incremental cash inflows are expected to decline beginning in Year 4 and are expected to end in Year 7.
- Project #188 has a payback period of 6 years. However, the amounts of its net incremental cash inflows are positive and are expected to grow exponentially from Year 4 through Year 15.
While Project #187's payback period is faster, Project #188 is a significantly better investment. Hence, the limitation of using the payback period for ranking potential investments.