Business – 10.3 Investment appraisal – Payback and ARR | e-Consult
10.3 Investment appraisal – Payback and ARR (1 questions)
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Two major limitations are:
- Ignores cash flows after the payback point: Any benefits that occur beyond the recovery period are not considered, potentially overlooking profitable long‑term projects.
- Does not incorporate the time value of money: All cash inflows are treated as if they have the same value, which can distort the true economic return, especially for projects with distant cash flows.
Despite these drawbacks, payback can be justified in situations where liquidity risk is paramount, such as:
- Start‑up firms with limited working capital that need to ensure rapid recovery of cash.
- Projects in industries with rapid technological change, where future cash flows are highly uncertain and the focus is on short‑term cash recovery.
In such contexts, the simplicity and speed of the payback calculation provide a useful preliminary filter before applying more sophisticated methods like NPV or IRR.