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What are three potential flaws with the regular payback method? Does the discounted payback method correct...

What are three potential flaws with the regular payback method? Does the discounted payback method correct all three flaws? Explain.

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Answer #1

The three flaws with the regular payback method

1. The concept of time value of money is ignored. It assumes a dollar today is equivalent to a dollar in future time.

2. It ignores the cash flows after the payback period. What if the payback period is 3 years and there is huge negative cash flow in year 4?

3. There is no basis to know what payback period is acceptable. Is payback period of 3 years is good? How about 4.5 years?

The discounted payback method only corrects the first flaw. It considers the time value of money. The other two flaws still exist in the discounted payback method as well.

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