What are the advantages and disadvantages of using the payback period as a decision criterion? (2024)

One of the main advantages of using the payback period as a decision criterion is its simplicity and ease of calculation. You only need to estimate the cash flows of the project and divide the initial investment by the annual cash inflow. This makes the payback period easy to understand and communicate to stakeholders, especially those who are not familiar with more complex methods of capital budgeting. Another advantage of the payback period is that it reflects the liquidity and risk of the project. A shorter payback period means that the project recovers its initial cost faster, which reduces the exposure to uncertainty and volatility in the future cash flows. A shorter payback period also implies that the project frees up cash for other uses sooner, which increases the liquidity and flexibility of the firm.

Despite its simplicity and popularity, the payback period also has some significant disadvantages that limit its reliability and validity as a decision criterion. One of the main disadvantages of the payback period is that it ignores the time value of money. The payback period treats all cash flows as if they occur at the end of each year, without discounting them to their present value. This means that the payback period does not account for the opportunity cost of capital, inflation, or interest rates. Another disadvantage of the payback period is that it ignores the cash flows that occur after the payback period. The payback period does not consider the profitability or return on investment of the project beyond the breakeven point. This means that the payback period may favor projects that have shorter but lower cash flows over projects that have longer but higher cash flows. A third disadvantage of the payback period is that it may be influenced by arbitrary cutoff points. The payback period requires a predetermined acceptable payback period, which may vary depending on the industry, the firm, or the manager. However, there is no objective or rational basis for choosing a specific payback period, and different cutoff points may lead to different decisions.

Given the disadvantages of the payback period, you may wonder what other methods of evaluating investment projects are available and how they compare to the payback period. Some of the common alternatives to the payback period are the net present value (NPV), the internal rate of return (IRR), and the profitability index (PI). These methods are based on the concept of discounted cash flow (DCF), which accounts for the time value of money and the risk-adjusted cost of capital. The NPV measures the difference between the present value of the cash inflows and the present value of the cash outflows of the project. A positive NPV means that the project adds value to the firm and should be accepted. The IRR measures the annualized rate of return that equates the present value of the cash inflows and the present value of the cash outflows of the project. A higher IRR means that the project is more profitable and should be preferred over other projects with lower IRRs. The PI measures the ratio of the present value of the cash inflows to the present value of the cash outflows of the project. A PI greater than one means that the project generates more value than it costs and should be undertaken.

The payback period can be a useful and practical tool for screening and comparing investment projects, as long as you are aware of its assumptions and implications. To use it effectively in P&L management, consider it a preliminary filter rather than a final decision criterion. Additionally, combine the payback period with other measures such as the discounted payback period or the average accounting return. Be sure to use caution and judgment when relying on the payback period, since it is not a perfect or universal measure of project viability or desirability. You should always consider the context and purpose of your decision, and use your own experience and intuition to supplement and validate your analysis.

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

P&L Management

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