What is a major limitation of the payback period criterion?

• A. It accounts for the time value of money.
• B. It considers all cash flows over the project life.
• C. It ignores the time value of money and cash flows beyond the payback period.
• D. It measures profitability precisely.

Answer: (C)

The main idea here is how the payback period treats cash flows over time. A major limitation is that it ignores the time value of money and ignores cash flows that occur after the initial investment has been recovered. Because it doesn’t discount future cash inflows, a dollar received in the future is treated the same as a dollar today, which can distort the true value of a project. It also stops counting once the break-even point is reached, so any cash flows that come later are completely ignored. As a result, the payback method tells you only how quickly you recover your investment, not how profitable the project actually is or how much value it creates over its life.

Choices that say it accounts for the time value of money or that it considers all cash flows over the project life are inconsistent with what the payback method does. And the idea that it measures profitability precisely is misleading because recovering money quickly doesn’t guarantee overall value or return.