The first is that it fails to take into account the time value of money (TVM) and adjust the cash inflows accordingly. The TVM is the idea that the value of cash today will be worth more than in the future because of the present day’s earning potential. This analysis method is particularly helpful for smaller firms that need the liquidity provided by a capital investment with a short payback period.
- Additional cash outflows may be required over time, and inflows may fluctuate in accordance with sales and revenues.
- Machine X would cost $25,000 and would have a useful life of 10 years with zero salvage value.
- As the payback period method is loved for its simplicity, it also extends to every aspect of the equation, naturally.
- In other words, it takes four years to accumulate $16,000 in cash inflow from the embroidery machine and recover the cost of the machine.
- The value of money can vary over time, especially when you are talking about steady, long-term investments.
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 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. Unlike other methods of capital budgeting, the payback period ignores the time value of money (TVM).
Advantages and Disadvantages of Payback Period Method
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.
- Many managers and investors thus prefer to use NPV as a tool for making investment decisions.
- Getting repaid or recovering the initial cost of a project or investment should be achieved as quickly as it allows.
- 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.
- The quicker a company can recoup its initial investment, the less exposure the company has to a potential loss on the endeavor.
The second project will take less time to pay back, and the company’s earnings potential is greater. Based solely on the payback period method, the second project is a better investment if the company wants to prioritize recapturing its capital investment as quickly as possible. Most capital budgeting formulas, such as net present value (NPV), internal rate of return (IRR), and discounted cash flow, consider the TVM.
Disadvantages of Payback Period Method
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. Since cash flows represent the actual variable overhead efficiency variance cash flow generated by a project, they are considered superior to accounting period. It Is Simple A significant percentage of companies use employees with different backgrounds to analyze capital projects which is not only biased but a difficult process to understand.
Practical Understanding through Pay-back Period Method Example
This process is continued year after year until the accumulated increase in cash flow is $16,000, or equal to the original investment. Payback period analysis ignores the time value of money and the value of cash flows in future periods. We can calculate payback using two formulas depending on whether a project generates even cash inflows or uneven cash inflows. Suppose a company gets a shorter payback period, which is the goal of the payback period.
What Is a Good Payback Period?
A dollar that you invest today is not going to be worth the same as one invested 20 years ago. The payback period method ignores everything after the initial investment is recouped by the business. One of the biggest advantages of using the payback period method is the simplicity of it. You base your decision on how quickly an investment is going to pay itself back, and that is done through forecasted cash flow.
BUS202: Principles of Finance
When engaged in a rough analysis of a proposed project, the payback period can probably be calculated without even using a calculator or electronic spreadsheet. It does not account for the fact that money received in the future is worth less than money received today due to factors such as inflation and the opportunity cost of capital. In this case, the
Initial Investment is the £75,000 required at the start of the project for equipment, marketing, and other costs. The
Annual Cash Inflows are the expected yearly returns of £15,000 from the project. When you start a project, returns could be higher or lower than predicted. These discrepancies are not taken care of in the payback period.
Advantages of payback period
Additional cash outflows may be required over time, and inflows may fluctuate in accordance with sales and revenues. When considering two similar capital investments, a company will be inclined to choose the one with the shortest payback period. The payback period is determined by dividing the cost of the capital investment by the projected annual cash inflows resulting from the investment. This budgeting tactic is purely focused on short-term cash flow and getting the fastest possible return, so it misses a lot of other considerations. The value of money can vary over time, especially when you are talking about steady, long-term investments.