Question

the payback period method has been criticised for not taking the time value of money into account. In modern finance, time value of money concepts play a central role in decision support and planning since the money to be received or paid at some time in the future should be treated as having less value, today, than an equal amount actually received or paid today. Could this limitation be overcome in payback period method? If so, would this method then be preferable to the NPV method? Please share your thoughts based on academic literature.

Answer 1

The limitation of payback period is overcome by the discounted payback period where the cash inflows are discounted with discounting factor, the discounting payback period give importance to time value of money and provides the number of years in which discounted cash inflow cover the initial investment.

The discounted payback period is not preferable to the NPV method because this method avoides the benefits of the project that is generated after the payback period and NPV method calculate the total dollar value of the project benefit.

NPV method is also provide better picture of the project because benefits are calculated in monetary terms so that decision making become easier for investors. On the other hand, discounted payback period calculate the number of years that is not useful for decesion making because the comparison between different size of project is not possible.