Some of the common alternatives to payback period are net present value (NPV), internal rate of return (IRR), and profitability index (PI). These methods take into account the time value of money and the total cash flows of a project. They also help you determine the optimal capital budgeting decision or the best combination of projects or investments that maximize your wealth.
- If a business is just looking to see how quickly they can break even on their investment, this is fine, but that is certainly not always the case.
- Many managers and investors thus prefer to use NPV as a tool for making investment decisions.
- The problem with this method is that it obscures or manipulates long-term assessments, which can distort the true viability of certain projects.
- The choice of the maximum acceptable payback period depends on the preferences and expectations of the decision makers.
If a payback period is larger than targeted period, the project would be rejected. This is considered the first screening method, but organizations may use any other techniques to appraise the project. The organization considers the net cash inflows to appraise to appraise the project, Net Cash inflows means Profit after tax plus Depreciation.
1 Payback Period Method
Payback Period is the time where a project’s net cash inflows are equal to the project’s initial cash investment. This method is often used as the initial screen process and helps to determine the length of time required to recover the initial cash outlay (investment) in the project. Initially the project involves a cash outflow, arising from the original investment of £500,000 and some project losses in Year 1 of £50,000. Ignores Time Value of Money The method ignores the time value of money. Investments are usually long term and continue to generate income even long after they have paid back their initial start-up capital.
As an investor, you can compare viable projects, potential returns, and payback periods with economic and political risks. You can then decide when a project should have returned capital invested and profit. One of the main advantages of the payback period is that it is simple to calculate and does not require much complexity. Determining which project will repay your capital soonest takes a relatively short time. If your investment finances are limited, you correctly eliminate projects with longer payback periods. The discounted payback period indicates the profitability of a project while reflecting the timing of cash flows and the time value of money.
When there is not much else to differentiate multiple projects, a manager is going to need all the information and help he/she can get to make a decision. Since this analysis favors projects that return money quickly, they tend to result in investments with a higher degree of short-term liquidity. This is a useful concept during times when long-term returns on investment are uncertain. It does not take into account the cash flow after the payback period. With such a limited perspective of cash flows, you may need to pay attention to a project that might generate significant cash flows in its later years.
Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM. So if you pay an investor tomorrow, it must include an opportunity cost. People and corporations mainly invest their money to get paid back, which is why the payback period is so important. In essence, the shorter payback an investment has, the more attractive it becomes. Determining the payback period is useful for anyone and can be done by dividing the initial investment by the average cash flows. 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.
A business can quickly get themselves into trouble if they have too much of their money tied up in investments with no way of quickly getting at it. The payback period method will help by showing management the right investments to focus the percentage of completion method and formula explained on to keep liquidity in the business for further growth. However, we know that money has a time value, and receiving $6,000 in year 1 (as occurs in Project C) is preferable to receiving $6,000 in year 5 (as in Projects B and D).
What are the advantages and disadvantages of using the payback period as a decision criterion?
In a nutshell, payback period helps you have a better control of both long term and long term business liquidity. A few inputs are needed to help corporate managers make effective decisions important to the company’s growth. With shallow knowledge of project evaluation, one can identify the better project from viable alternatives.
Net Present Value Method Vs. Payback Period Method
It measures how long it takes to recover the initial outlay or cost of the project from the cash flows it generates. For example, if a project costs $10,000 and generates $2,000 per year, the payback period is five years. In this article, we will discuss the advantages and disadvantages of using payback period as a performance measure. Payback period can be a helpful tool for preliminary analysis and comparison, but it is not a sufficient criterion for capital budgeting. Payback period should be used as a screening tool, not as a ranking tool, to eliminate projects that are too risky or unprofitable.
The Advantages and Disadvantages of the Internal Rate of Return Method
The discounted payback period is used to evaluate the profitability and timing of cash inflows of a project or investment. In this metric, future cash flows are estimated and adjusted for the time value of money. It is the period of time that a project takes to generate cash flows when the cumulative present value of the cash flows equals the initial investment cost. It indicates how long it will take for your project to generate enough inflows to cover your investment. A shorter payback period makes a project more appealing because it means that your investment costs can be recovered in a shorter period of time.
Once we’ve calculated the discounted cash flows for each period of the project, we can subtract them from the initial cost figure until we arrive at zero. The shorter the discounted payback period, the quicker the project generates cash inflows and breaks even. While comparing two mutually exclusive projects, the one with the shorter discounted payback period should be accepted. The discounted payback period is often used to better account for some of the shortcomings, such as using the present value of future cash flows. For this reason, the simple payback period may be favorable, while the discounted payback period might indicate an unfavorable investment.
Payback Period Formula
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. The choice of the maximum acceptable payback period depends on the preferences and expectations of the decision makers.
Limitations of Using a Payback Period for Analysis
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.