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Payback Period Method
Payback is the number of years required to recover the original cash flow outlay investment in a project. Payback is one of the most popular and widely accepted traditional methods of evaluating investment proposals. If the project generates consistent annual cash flows, the payback period can be calculated by dividing the cash outlay by the annual cash flows. It is:
Payback = Initial Investment / Annual Cash Flow
Many companies use payback period as an investment evaluation criterion and method of ranking projects. They compare the payback of projects with a predetermined, standard payback. A project will be accepted if its payback period is less than the maximum or standard payback period determined by the management. As a ranking method, it gives the highest ranking to the project with the shortest payback period and the lowest ranking to the project with the shortest payback period. Thus, if a firm has to choose between two mutually exclusive projects, the project with the shorter payback period will be chosen.
Benefits of Payback
Payback is a popular investment criterion in practice. It is believed to have certain qualities.
• Simplicity. The most important quality of payback is that it is easy to understand and easy to calculate. Business executives consider simplicity of method a virtue. This is evident in their heavy reliance on it to evaluate investment proposals in practice.
• Cost effective. The cost of the payback method is lower than most sophisticated techniques that require a lot of analyst time and computer use.
• Short term effects. Investors can have a more favorable short-term impact on earnings per share by setting a shorter standard payback period. However, it should be remembered that this may not be a wise long-term strategy as the investor may have to sacrifice future growth for current earnings.
• Risk shield. Project risk can be addressed by a shorter standard payback period as it can guarantee against losses. An investor has to invest in many projects where cash is involved and the life expectancy is highly uncertain. In such cases, returns may become important, not as a measure of profitability but as a means of establishing an upper limit on the acceptable amount of risk.
• Liquidity. Payback focuses on early recovery of investment. Thus, it gives an insight into the liquidity of the project. Funds so released can be put to other uses.
Disadvantages of Payback
In its sense of simplicity and so-called virtue, return may not be a desirable investment criterion because it has several serious limitations:
• Cash flow after repayment. Payback fails to account for cash earned after the payback period.
• Ignore cash flow. Payback is not an appropriate method of measuring the profitability of investment projects because it does not consider all cash flows from the project.
• Cash flow patterns. Payback fails to consider the pattern of cash flows. ie the quantity and timing of cash flows. In other words, it gives equal weight to returns of the same magnitude even if they occur over different periods.
• Administrative difficulties. A firm may face difficulties in determining the maximum acceptable payback period. There is no rational basis for setting a maximum repayment period. This is generally a subjective decision.
• Inconsistent with shareholder value. The payback is not consistent with the objective of increasing the market value of the firm’s shares. Share values do not depend on the payback period of investment projects.
Let us emphasize again that payback is not a valid method for evaluating the acceptability of investment projects. However, it can be used as a first step to roughly screen projects with net present value rules. In practice, the use of discounted cash flow techniques is increasing but payback remains the popular and primary method of investment evaluation.
Payback is theoretically useful in some situations. An important argument in favor of payback is that its correlation is a good predictor of the rate of return under certain conditions.
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