Payback method helps in revealing the payback period of an investment. Payback period (PBP) is the time (number of years) it takes for the cash flows of incomes from a particular project to cover the initial investment. When a CFO faces a choice, he will prefer the project with the shortest payback period.
As the name suggests, this method refers to the period in which the proposal will generate cash to recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in the project, with no consideration to time value of money. Through this method selection of a proposal is based on the earning capacity of the project.
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.
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.
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.
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.