Section 4 of 6
| Advantages | Limitations |
|---|---|
| Easy to calculate and understand | Ignores all cash flows after the payback period |
| Emphasises early cash flows, which are more likely to be accurate estimates | Ignores the time value of money (unlike NPV) |
| Ideal for high-technology or fashion projects where obsolescence is a risk | Ignores the timing of cash flows within the payback period (e.g. does not distinguish whether Year 1 cash flow is high or low) |
| Highlights liquidity — useful for businesses that need to recover funds quickly | Ignores inflation |
| Widely used in practice | Relies on estimated future information, which may be wrong |
| Ignores the total length of the asset's life | |
| Does not consider the weighting of receipts — one project may have higher early inflows than another |
| Advantages | Limitations |
|---|---|
| Considers the time value of money — unlike payback | More complex to calculate than payback |
| Considers all cash flows over the whole life of the asset | The cost of capital (discount rate) is difficult to ascertain accurately and may vary over time |
| Takes into account the timing of cash flows | The meaning of NPV is not always clear to non-accountants |
| Once discount factor tables are available, calculations are relatively straightforward | The project with the higher NPV may not produce the best quality output |
| Relies on estimated future information, which may be wrong — especially for long-term projects |
A business may require a project to satisfy both criteria before proceeding:
A project that fails either criterion would be rejected. When two projects conflict (different payback rankings vs NPV rankings), NPV is generally considered the more robust method because it accounts for the time value of money.
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