Payback Period
Payback period basically pays attention to the speed at which the initial investment made in a project will be recovered by subsequent cash flows. The project which helps recoup the investment the fastest is considered to be the best project and that is the project that the firm must dedicate its resources to.
Example:
Let’s say that there are 2 projects A and B. Both require an equal outlay of $2000. Project A pays back $1500 in year 1, $500 in year 2 and $500 in year 3. Project B on the other hand pays $750 for 4 consecutive years.
So, now in this case if we were to use the payback period rule. We could consider the period in which the initial $2000 investment is recovered. In case of Project A, we recover it in 2 years whereas in case of Project B it requires 3 years. So according to the payback rule, Project A is better than Project B and the company must clearly devote its finite resources to Project A before it decides whether or not to undertake Project B.
Advantages
The most significant advantage of the payback method is its simplicity. It’s an easy way to compare several projects and then to take the project that has the shortest payback time. However, the payback has several practical and theoretical drawbacks.
Disadvantages
Ignores the time value of money: The most serious disadvantage of the payback method is that it does not consider the time value of money. Cash flows received during the early years of a project get a higher weight than cash flows received in later years. Two projects could have the same payback period, but one project generates more cash flow in the early years, whereas the other project has higher cash flows in the later years. In this instance, the payback method does not provide a clear determination as to which project to select.
Neglects cash flows received after payback period: For some projects, the largest cash flows may not occur until after the payback period has ended. These projects could have higher returns on investment and may be preferable to projects that have shorter payback times.
Ignores a project’s profitability: Just because a project has a short payback period does not mean that it is profitable. If the cash flows end at the payback period or are drastically reduced, a project might never return a profit and therefore, it would be an unwise investment.
Does not consider a project’s return on investment: Some companies require capital investments to exceed a certain hurdle of rate of return; otherwise the project is declined. The payback method does not consider a project’s rate of return.
