Question

*Min of 300 words*

Discuss payback period and define the primary advantages and disadvantages of the method.

Answer 1

Payback period is a method of calculating how long it will take to recover the initial investment from a project's cash inflows. It is basically used as a comparison tool for various investment options when investor has limited funds. For example say Adam has $15000 and he can invest it in either PLAN A or PLAN B. Plan A gives $3000 annual cash inflow whereas Plan B will give $5000 annual cash inflow. By payback period we see that investment of $15000 will be recovered from Plan A within 5 years ($15000 / $3000 per year), whereas in Plan B, investment will be recovered in 3 years ($15000/ $5000 per year). Thus he can select the Plan which helps recovering initial investment in the least number of years (PLAN B)

Advantages of Payback period are as follows:
1- SIMPLICITY- The most basic advantage of Payback period is it's simplicity as can be seen from above example that how easy it is to calculate payback period once you have the initial Cash outflow and Cash inflows from investment. Compared to other Capital budgeting methods, it is by far the easiest.
2- TIME SAVING- Another primary advantage of payback period method is that answer is available quickly. Management needs to take important investment decisions and have limited time to come to the conclusion which offers most benefit in the least amount of time
3- LIQUIDITY- It is generally used by small businesses who needs to recover their investment in the shortest amount of time so that once their initial investment is liquidated than they can re-invest it in some other investment opportunity available
4- UNCERTAINTY- Another advantage of Pay back period method is that industries (mostly small scale) who are not certain about the future cash inflows of their investment can reduce such risks by using payback period and investing in plans with the shortest payback of initial investment

Disadvantages of Payback period are as follows:
1- NO TIME VALUE OF MONEY- It is known that a particular amount of money received today is worth more than same amount received after a couple of years so that it can earn some interest when it is re-invested but in Payback period method, Time value of money is not considered at all.
2- ONLY INITIAL INVESTMENT COVERED- The Payback period is concerned with only when the initial investment will be recovered but cash inflows after that is not considered. So even if it is beneficial to keep the funds invested in the same plan, such benefits are not revealed in Payback period method.
3- UNREALISTIC- Payback period is based on concept that investment is made only once but such is not actual case when it comes to various investment scenarios as different investment plans may involve more that one time cash outflow in the following years. Such is ignored in Payback period method.
4- PROFITABILITY IGNORED- Basically for any company, investment is primarily done to earn profit but such is not shown or differentiated in Payback period. It may happen that cash inflows reduce after initial investment is recovered but such is not shown in Payback period method