KNEC Past paper for college diploma business finance question with answer
Question: Highlight two disadvantages of using Pay Back Period (PBP) as a method of investment
The payback period (PBP) is a simple project appraisal technique. It is used to evaluate the viability of investment projects by measuring the number of years that a project takes to recoup the initial investment. There are several disadvantages of using payback period as a method of evaluating investment projects:
- It does not consider the time value of money. Over time, money tends to lose value due to factors such as discounting rate or inflation, meaning cash flows for today are more valuable than the same amount in the future.
- It ignores the cash flows generated after the payback period. An investment may take long to make profits, but it may give more returns later. So, the disadvantage of using payment period as an investment appraisal technique is because it has a short term focus.
- It does not consider profitability; every business aims to make profits from various projects, but the PBP does not consider the overall return on investment or profits of the project.
- PBP does not measure risk; another disadvantage of using payback period method to evaluate investment projects is because it does not include risk assessment in its approach.
- Discourages long term projects: Payback period enables investors to choose projects that generate more revenue early on, may be within 2-3 years; hence becoming biased against long term projects.
