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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.