Which capital budgeting method ignores the time value of money
Asked by admin @ in Business viewed by 268 People
The payback method, unlike the net present value method, does not ignore cash flows after the point of cost recovery.
a. True
b. False
Answered by admin @
Answer:
Explanation:
The payback period measures the length of time it takes a project cash inflow s to recoup its cash outflows.
Though it does not incorporate time value of money but it is a sure measure of a project's liquidity- it gives an idea of how soon it will take a project to recover its initial cost. In addition, it is very easy to calculate.
However, it suffers a number of setbacks. For example, it treats cash flows occurring at different periods in the project life as been the same- it ignores the time value of money concept.
Furthermore, it also excludes cash inflows coming up after the payback date in its computation. The date at which the accumulated cash inflows equals the initial cost is also known as point of cost recovery
The payback period is a method of investment appraisal which focuses on liquidity and not profitability. Yes, it is concerned about a project breaking even but investors are concerned about profitable.
In contrast, the net present value corrects some of the major pitfalls of the payback period method. For example, It uses the concept of time value of money as it involves calculating the present values of cash flows.
Also, all cash flows are included in the calculation of net present value.
Note that the question negates some of these points.
For example if a project costs $60,000 with a seires of annual cash inflows as follows Year 1- $20,000, year 2- $20,000, year 3 -$20,000 and year 4- $10.
The payback period is 3 year in this example of mine. The $10 of year 4 is excluded in the computation of the payback perod and does give an idea of whether the project is profibale
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