Limitations of Using a Payback Period for Analysis

Additional cash outflows may be required over time, and inflows may fluctuate in accordance with sales and revenues. The payback period is a simple and popular method of evaluating the profitability of an investment project. It measures how long it takes for the initial cash outlay to be recovered by the cash inflows generated by the project. However, using the payback period as a decision criterion also has some drawbacks that limit its usefulness and accuracy. In this article, you will learn about the advantages and disadvantages of using the payback period as a decision tool in P&L management.

If short-term cash flows are a concern, a short payback period may be more attractive than a longer-term investment that has a higher NPV. Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM. So if you pay an investor tomorrow, it must include an opportunity cost.

Company XYZ is considering an investment in a project that requires an initial cash outflow of N100,000. This is because of its simplicity; it fails to recognize everyday business scenarios. Businesses need to have liquid capital in their day-to-day operations. Management must understand the right investments to pursue to keep liquidity in the business for more growth. In this guide, we’ll be covering what the payback period is, what are the pros and cons of the method, and how you can calculate it, with concrete business examples.

Pay-back Period Method – Key takeaways

For example, if a company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired payback period of the company would be 5 years. The purchase of machine would be desirable if it promises a payback period of 5 years or less. The payback period method really is a short-term only type of budgeting.

  • No argument exists for a company to use a payback period of three, four, five, or any other number of years as its criterion for accepting projects.
  • This is considered the first screening method, but organizations may use any other techniques to appraise the project.
  • The payback period does not consider the profitability or return on investment of the project beyond the breakeven point.
  • In its simplest form, the payback period is calculated by dividing the initial investment by the annual cash inflow.
  • According to payback period analysis, the purchase of machine X is desirable because its payback period is 2.5 years which is shorter than the maximum payback period of the company.

It isn’t always going to be about how fast you can get your money back. In the world of business, it is utterly essential that you have the liquid capital to be able to run day-to-day operations and to make investments in the future of the company. A business can quickly get themselves into trouble if they have too much of their money tied up in investments with no way of quickly getting at it. The payback period method will help by showing management the right investments to focus on to keep liquidity in the business for further growth. The payback period can be a valuable tool for analysis when used properly to determine whether a business should undertake a particular investment.

Alternatives to payback period

This is why you should combine the payback period technique with other capital budgeting methods to visualize a project’s earned value in the future. Return on Investment (ROI) is the annual return you receive on investment, and it measures the efficiency of the investment, compared to its cost. A high ROI means the investment’s gains are greater than its cost.

Understanding the Pay-back Period Method

That’s why business owners and managers need to use capital budgeting techniques to determine which projects will deliver the best returns, and yield the most profitable outcome. This method provides a more realistic payback period by considering the diminished value of future cash flows. According to payback method, machine Y is more desirable than machine X because it has a shorter payback period than machine X. Delta Company is planning to purchase a machine known as machine X. Machine X would cost $25,000 and would have a useful life of 10 years with zero salvage value. Unlike net present value , profitability index and internal rate of return method, payback method does not take into account the time value of money.

Disadvantages of Payback Period Method

A modified variant of this method is the discounted payback method which considers the time value of money. The payback method of evaluating capital expenditure projects is very popular because it’s easy to calculate and understand. It has severe limitations, however, and ignores many important factors that should be considered when evaluating the economic feasibility of projects. The breakeven point is the price or value that an investment or project must rise to cover the initial costs or outlay. The payback period refers to how long it takes to reach that breakeven. This period does not account for what happens after payback occurs.

Major Advantages and Disadvantages of the Payback Period

In most cases, this is a pretty good payback period as experts say it can take as much as years for residential homeowners in the United States to break even on their investment. If a business is looking to recoup their investments so they can continuously keep reinvesting and growing, this method is going to make things quick and easy. You are able to see which investments are going to pay you back the fastest, or most efficiently, and use this information to invest in the right things. If it is all about growing your business, you want to constantly have your money working for you through the right investment opportunities. Consequently, despite its lack of rigorous analysis, there are situations in which the payback period can be used to evaluate prospective investments. We suggest that it be used in conjunction with other analysis methods to arrive at a more comprehensive picture of the impact of an investment.

People and corporations mainly invest their money to get paid back, which is why the payback period is so important. In essence, the shorter payback an investment has, the more attractive it becomes. Determining the payback period is useful for anyone and can be done by dividing the initial investment by the average cash flows. Recouping the initial cost of a project or investment must be fast. However, not all projects and investments have the same time horizon, so the shortest payback period must fall within that range. The payback period on a home repair project may be decades, but a construction project may be five years or less.

Since cash flows represent the actual cash flow generated by a project, they are considered superior to accounting period. If a payback period is larger than targeted period, the project would be rejected. This is considered the first screening method, but organizations may use any other techniques to appraise the project. The organization considers the net cash inflows to appraise to appraise the project, Net Cash inflows means Profit after tax plus Depreciation.

Assume Company A invests $1 million in a project that is expected to save the company $250,000 each year. If we divide $1 million by $250,000, we arrive at a payback period of four years for this investment. Conversely, evaluation plan for grant proposal the longer the payback, the less desirable it becomes. For example, if solar panels cost $5,000 to install and the savings are $100 each month, it would take 4.2 years to reach the payback period.

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