Payback Period, Advantages, Disadvantages

Payback Period is a capital budgeting method used to determine the time required to recover the initial investment of a project. It measures how long a business takes to generate enough cash inflows to cover its initial costs. A shorter payback period indicates a quicker recovery of investment, reducing risk and improving liquidity. However, this method ignores the time value of money and cash flows beyond the payback period. Despite its simplicity, companies often use it alongside other evaluation techniques like Net Present Value (NPV) and Internal Rate of Return (IRR) for better investment decision-making.

Payback period = Cash outlay (investment) / Annual cash inflow

With simple calculations, selection or rejection of the project can be done, with results that will help gauge the risks involved. However, as the method is based on thumb rule, it does not consider the importance of time value of money and so the relevant dimensions of profitability.

Advantages of Payback Period:

• Simple to Use and Easy to Understand

This is among the most significant advantages of the payback period. The method needs very few inputs and is relatively easier to calculate than other capital budgeting methods. All that you need to calculate the payback period is the project’s initial cost and annual cash flows. Though other methods also use the same inputs, they need more assumptions as well. For instance, the cost of capital, which other methods use, requires managers to make several assumptions.

• Quick Solution

Since the payback period is easy to calculate and need fewer inputs, managers are quickly able to calculate the payback period of the projects. This helps the managers to make quick decisions, something that is very important for companies with limited resources.

• Preference for Liquidity

The payback period is crucial information that no other capital budgeting method reveals. Usually, a project with a shorter payback period also has a lower risk. Such information is extremely crucial for small businesses with limited resources. Small businesses need to quickly recover their cost so as to reinvest it in other opportunities.

• Useful in Case of Uncertainty

The payback method is very useful in the industries that are uncertain or witness rapid technological changes. Such uncertainty makes it difficult to project the future annual cash inflows. Thus, using and undertaking projects with short PBP helps in reducing the chances of a loss through obsolescence.

Disadvantages of Payback Period:

• Ignores Time Value of Money

This is among the major disadvantages of the payback period that it ignores the time value of money which is a very important business concept. As per the concept of the time value of money, the money received sooner is worth more than the one coming later because of its potential to earn an additional return if it is reinvested. The PBP method doesn’t consider such a thing, thus distorting the true value of the cash flows. Here, there is a workaround. One can use the Discounted Payback Period that can do away with this disadvantage.

• Not All Cash Flows Covered

The payback method considers the cash flows only till the time the initial investment is recovered. It fails to consider the cash flows that come in subsequent years. Such a limited view of the cash flows might force you to overlook a project that could generate lucrative cash flows in their later years.

• Not Realistic

The payback method is so simple that it does not consider normal business scenarios. Usually, capital investments are not just one-time investments. Rather such projects need further investments in the following years as well. Also, projects usually have irregular cash inflows.

• Ignores Profitability

A project with a shorter payback period is no guarantee that it will be profitable. What if the cash flows from the project stop at the payback period, or reduces after the payback period. In both cases, the project would become unviable after the payback period ends.

Neglects project’s return on investment – some companies require their capital investments to earn them a return that is well over a certain rate of return. If not, the project is scrapped. However, the payback method ignores the project’s rate of return.