What are the advantages and disadvantages of using payback period as a capital budgeting method? (2024)

Payback period is the number of years or periods required for the net cash inflows from a project to equal its initial outlay. For example, if you invest $10,000 in a project that generates $2,000 per year, the payback period is five years. The shorter the payback period, the faster you can recover your investment and the less risky the project is.

There are two ways to calculate payback period: simple and discounted. The simple payback period ignores the time value of money and assumes that the cash flows are constant and equal. To calculate it, you simply divide the initial cost by the annual cash flow. The discounted payback period takes into account the time value of money and discounts the future cash flows at a certain interest rate. To calculate it, you need to find the present value of each cash flow and then add them up until they equal or exceed the initial cost.

Payback period has some advantages as a capital budgeting method. First, it is easy to understand and calculate. You don't need complex formulas or data to estimate the payback period of a project. Second, it is useful for screening projects that have high risk or uncertainty. By setting a maximum acceptable payback period, you can eliminate projects that take too long to recover their cost and expose you to more volatility. Third, it is consistent with the goal of maximizing shareholders' wealth. By favoring projects that pay back sooner, you can reinvest the cash flows in other profitable opportunities and increase the value of the firm.

Payback period also has some disadvantages as a capital budgeting method. First, it ignores the cash flows after the payback period. This means that it may reject projects that have lower payback periods but higher net present values or internal rates of return. For example, a project that pays back in four years but has a negative net present value is worse than a project that pays back in six years but has a positive net present value. Second, it ignores the time value of money. The simple payback period does not account for the fact that a dollar today is worth more than a dollar in the future. The discounted payback period does consider the time value of money, but it still ignores the cash flows after the payback period. Third, it is arbitrary and subjective. The choice of the maximum acceptable payback period depends on the preferences and expectations of the decision makers. There is no objective or rational way to determine the optimal payback period for a project.

Payback period can be a helpful tool for preliminary analysis and comparison, but it is not a sufficient criterion for capital budgeting. To use payback period effectively, it is recommended to use the discounted payback period instead of the simple payback period, as it takes into account the time value of money and the risk of the project. Payback period should be used as a screening tool, not as a ranking tool, to eliminate projects that are too risky or unprofitable. It should also be used in conjunction with other criteria, such as profitability index, accounting rate of return, or break-even point, to capture the overall profitability or efficiency of a project before making a final decision.

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