[MUSIC] While NPV, IRR, and payback period help managers decide on which projects to accept or reject, they have their drawbacks. In this video, we will discuss some of these drawbacks, and discuss any possible fixes to these drawbacks. We will start with drawbacks of payback period. One drawback is that it ignores time value of money. We have seen earlier in the course that cash flows occurring at different points in time cannot be added, subtracted, or compared directly. They need to be aligned at the same point in time through discounting or compounding before they may be added, subtracted, or compared with each other. This drawback of the payback period can be fixed using a discounted payback period method. Here we discount all cash flows back to today and then we see how soon we recover the initial investment. Let's revisit our earlier example of a project with an initial investment of $1 million followed by annual cash flows of $200,000 for nine years. We found its payback period to be five years. The project had a discount rate of 15% per year. The discounted payback period requires us to discount all cash flows back to 0. The present value of the first year's $200,000 is 200,000 / 1 + 0.15 raised to the power of 1, which gives us 173,913. Similarly, the present value of the second year's cash flow is 200,000 / 1 + 0.15 to the power of 2, which is 151,229. We can similarly calculate the present values of each year's cash flows, I'll let you do this. Once we have the present values, we can start adding the present values to the initial investment of $1 million. We recover 173,193 in the first year, which means we're yet to recover 1 million minus 173,913, which is 826,087. We recover 151,229 in the second year, subtracting that from 826,087, we have to recover 674,858 after the second year. We continue doing this for every year and we find that we still haven't recovered 45,683 at the end of nine years. So while payback period showed that we recovered the initial investment of 1 million in five years, discounted payback shows that we don't even recover the initial investment at the end of the life of the project, after nine years. So this project looks even less attractive once we use discounted payback period. Another drawback of payback period is the threshold or acceptable value. With NPV and IRR, there's an economic rationale for threshold value. Positive NPV means that the project adds to shareholder wealth, whereas a negative value reduces shareholder wealth. An IRR greater than the hurdle rate, shows that the project returns more than the cost of capital. While an IRR less than the hurdle rate, says that the project returns less than the cost of capital. However, there is no economic rationale for what is an acceptable payback period and what is not. We may say that a project is acceptable if its payback period is three years or less. But why is a project with a payback period of greater than three years not acceptable? So payback period may be based on arbitrary decisions. A third drawback of payback period is that it ignores cash flows once the initial investment is recovered. This is especially problematic if the project requires additional investment or has large losses later in its life. We may accept a project with a short payback period even though the large negative cash flows later in the project's life make it unattractive. Despite all these drawbacks, managers still use payback period to decide which projects to accept and which ones to reject. It still provides an easy way to determine how quickly a manager can recover the initial investment. Next time, we will discuss drawbacks of using IRR and NPV as decision tools. And look at possible fixes to these drawbacks. [MUSIC]
