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What are the limitations of the payback period?

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:

  1. 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.
  2. 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.