Payback Period
The time, in no. of years, needed to recover a project’s initial outlay of cash flow investment is called payback. It is the most highly utilized traditional way of determining the value of investment proposals and is even the most popular one. Payback period in a project generating consistent yearly cash inflows, it can be calculated by dividing outlay of cash by the yearly cash inflow, which is:
Payback = original investment / yearly Cash inflow
Acceptance Rule
Many companies utilize the payback period as an investment evaluation measure and a method of ranking their projects. Comparison of the project’s payback with a standard, predetermined payback is done. The project is accepted only if it has actual payback period less than the standard or maximum payback period the management sets for it. When it is used as a method for ranking, highest rank is given to that project, which has the least amount of payback period and the project with the highest payback period is given the lowest rank. Therefore, if a firm has to make a choice between two projects, the project which has the shorter payback time period will be chosen.
Advantages of Payback
In practice, Payback is the most widely used investment criterion. It is considered to have some specific virtues.
• Simplicity: The most important advantage of payback is that it’s easy to comprehend and simple to compute. In practice, business executives rely heavily on payback period calculations for appraising of investment proposals.
• Cost effectiveness: Payback method costs significantly less than most of the newer, complicated techniques that take up a lot of time of the analyst and require computer usage.
• Shielding from risks: The risk involved in a project may be reduced by taking a smaller standard payback period as guarantee against loss might be ensured by this. When an investor has to invest in projects where life expectancies and cash inflows are very uncertain, payback can become important, not as a means of measuring profitability but for placing an upper limit on the acceptable amount of risk.
• Liquidity: Early recovery of the investment is the main motive behind payback. Hence, it gives an idea about the liquidity of the project. The funds released so could be put to other uses.
Payback Disadvantages
Due to the idea of maintaining simplicity and other virtues, payback might not prove to be a useful investment criterion under many circumstances, as:
• Cash will flow after a payback. But payback fails account for the cash inflows occurring after the time of payback period.
• All Cash flows yielded by the project are not accounted. Thus, payback is not an apt way of determining the gainfulness of an investment in a project.
• Patterns of cash flow: Payback does not consider the pattern that is timing and magnitude of inflows of cash. of cash inflows. Simply said, it does not keep a track of the time of return of same amounts and gives them equal weights.
Written by: Matt
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