The payback method uses undiscounted cash flows and thus does not incorporate the time value of money in the analysis. That is one of its weaknesses. Another weakness is that it does not take into account any cash flows that are received after the payback point has been reached.
The payback method does not use discounted cash flow techniques, and that is one of its weaknesses.
The payback method does not take into account any cash flows expected to be received after the payback point has been reached.
The payback method does not necessarily lead to the same decision as other methods of analyzing long-term projects do. Here are some examples of how and why the payback method can lead to a different accept-reject decision from the Net Present Value method: The payback method ignores all cash flows beyond the payback period. For example, a company may require that a project achieve payback within 3 years. A project with large expected cash flows in Year 4 but lower expected cash flows in Years 1 through 3 could easily fail that test. However, if the same project is evaluated for its Net Present Value, that project might have a very high NPV. So the payback method would lead to a "reject" decision whereas the NPV method would lead to an "accept" decision. Since the payback method does not use discounting of future cash flows, the cost of capital is not included in a payback analysis. The only place the cost of capital is included in a capital budgeting cash flow analysis is in calculation of the present value of expected future cash flows. A project might appear acceptable using the payback method because the initial investment is recouped within the company's required time period. But when the same project is evaluated using the present value of future expected cash flows, discounted at the company's cost of capital, it may have a negative NPV.
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