Last updated on Nov 16, 2023
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Ignores cash flows after payback period
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Lacks a clear acceptance criterion
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Fails to account for risk and uncertainty
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Here’s what else to consider
The payback period method is a simple and popular way to evaluate 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, this method has some serious limitations that may affect its reliability and usefulness for capital budgeting and risk analysis. In this article, you will learn about four of these limitations and how they can impact your decision making.
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- Helena Lauchli, CPA, MACCT Follow Me Through My Accounting Career
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1 Ignores time value of money
One of the main drawbacks of the payback period method is that it ignores the time value of money, which means that it does not account for the fact that a dollar today is worth more than a dollar in the future. This is because money can be invested to earn interest or inflation can erode its purchasing power over time. Therefore, the payback period method does not reflect the true profitability of a project, as it does not discount the future cash flows to their present value. For example, a project that pays back $10,000 in five years is not equivalent to a project that pays back $10,000 in ten years, even if they have the same initial cost.
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The time value of money disadvantage can be eliminated by using the DICOUNTED PAYBACK.Looking at the Net Present Value of the future cash flow 😀
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See AlsoThe Payback Method: Disadvantages of the Payback Method | Saylor AcademyDiscounted Payback PeriodLimitations of Using a Payback Period for AnalysisHow to calculate and reduce payback periodSupport
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The payback period method is a simple capital budgeting technique that calculates the time it takes for an investment to recover its initial cost. While it has its merits, there are several limitations associated with the payback period method:1.Ignores Time Value of Money:2.Ignores Cash Flows Beyond Payback Period:3.Does Not Consider Profitability:4.No Consideration of Risk:5.Biased Toward Short-Term Projects:6.No Consideration of Cash Flow Patterns:7.Subject to Manipulation:8.No Clear Criteria for Decision-Making:9.Limited Applicability for Complex Projects:10.Ignores Discounted Cash Flows:While the payback period method has its limitations, it can still be a useful preliminary tool for screening projects.
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The payback period method can be a useful preliminary screening tool for assessing the time it takes to recoup an initial investment. However, it is often recommended to use other capital budgeting techniques, such as net present value (NPV) and internal rate of return (IRR), in conjunction with the payback period to make more informed investment decisions.
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- Khizer Rajput ✓ Internal Audit Executive
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The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk,financing, or other important considerations, such as the opportunity cost.
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2 Ignores cash flows after payback period
Another limitation of the payback period method is that it ignores the cash flows that occur after the payback period is reached. This means that it does not consider the total return or the residual value of a project, which may be significant for long-term investments. For example, a project that has a payback period of three years and generates $5,000 of cash flow per year for ten years may be more profitable than a project that has a payback period of two years and generates $4,000 of cash flow per year for five years, even if they have the same initial cost.
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- Helena Lauchli, CPA, MACCT Follow Me Through My Accounting Career
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For instance, imagine two projects with identical initial costs. Project A boasts a payback period of three years, generating $5,000 of cash flow per year for a decade. Meanwhile, Project B, with a shorter payback period of two years, yields $4,000 of cash flow annually for only five years. The payback period alone may suggest Project B as more favorable, yet, this oversimplified metric obscures the fact that Project A continues to generate positive cash flows for an additional five years, potentially making it more profitable over the long term.
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3 Lacks a clear acceptance criterion
A third limitation of the payback period method is that it lacks a clear and consistent acceptance criterion for choosing among alternative projects. Unlike other methods, such as the net present value (NPV) or the internal rate of return (IRR), the payback period method does not provide a single value or a threshold that can be used to rank or compare projects. Instead, the payback period method relies on a subjective and arbitrary cut-off point that may vary depending on the preferences or expectations of the decision maker. For example, some investors may prefer a shorter payback period, while others may accept a longer one, depending on their risk tolerance or opportunity cost.
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4 Fails to account for risk and uncertainty
A fourth limitation of the payback period method is that it fails to account for the risk and uncertainty associated with the future cash flows of a project. It assumes that the cash flows are certain and constant, which may not be realistic for many investments. For example, a project that has a high degree of variability or unpredictability in its cash flows may have a different risk profile than a project that has a low degree of variability or predictability in its cash flows, even if they have the same payback period. Therefore, the payback period method does not adjust the cash flows for their riskiness or incorporate any risk premium or discount factor that may be required by the investors.
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5 Here’s what else to consider
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?
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- Rakesh Bembey Profitability and Cash Flow Expert | Driving Business Growth through Process Optimisation | Helping USD 25 million export company grow profitably year after year
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Payback period method is a quick thumb rool method of evaulating a project. However, as already listed in this article it has certain limitations - time value of money, cash flows beyond pay back period, does not consider risk and uncertainity, etc. Other limitations are - a) it does not consider opportunity cost - that is, what will be return if we invest the same money somewhere else. So other investment may yield a better return. b) this method does not take into account where the surplus being generated is being re-invested and return on that.
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In practical terms, two projects with the same payback period may differ significantly in post-payback cash flows. The method, however, fails to distinguish between these variations. While the payback period method is user-friendly, its inability to account for the time value of money and long-term cash flows makes it imperative to recognize these limitations before relying on it for investment decisions.
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