Advantages & Disadvantages of Payback Period
Payback period advantages include the fact that it is very simple method to calculate the period required and because of its simplicity it does not involve much complexity and helps to analyze the reliability of project and disadvantages of payback period includes the fact that it completely ignores the time value of money, fails to depict the detailed picture and ignore other factors too.
In many businesses, capital investmentsCapital InvestmentsCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.read more are obligatory. Say, as an example, investment in plant & machinery, furniture & fittings, and land & buildings, to name a few. But, such investments do incur a lot of money outlays. And business homes certainly are going to be anxious to know when they will recover such an initial cost of an investment. Below we have discussed some examples of payback period advantages & disadvantages to understand it better.
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Source: Payback Period Advantages and Disadvantages (wallstreetmojo.com)
Advantages
#1 – The formula is straightforward to know and calculate
You simply need the initial investment and the near term money flow information. The formula for calculating even cash flows or, in other words, the same amount of cash flow every period is:
Let us, now, see how easily it can be calculated under different circumstances –
Example #1
Caterpillar Inc. is considering the purchase of furniture & fittings for $30,000. Such furniture & fittings encompass a useful life of 15 years, and its expected annual cash inflow is $5,000. The company’s preferred payback period is 4 years. You need to find the payback period of the furniture & fittings and conclude whether or not buying such furniture & fittings is desirable?
The answer will be –
= ($30,000 / $5,000)
Payback period = 6 years
Thus, it may be concluded that the purchase of such furniture & fittings isn’t desirable as its payback period of 6 years is more than Caterpillar’s estimated payback period.
#2 – Payback Period Helps in Project Evaluation Quickly
Example #2
The Boeing Company is considering purchasing equipment for $40,000. The equipment has a useful life of 15 years, and its expected annual cash inflow is $40,000. But, the equipment has an annual cash outflow (including preservation expenses) of $30,000 as well. The aircraft manufacturer’s desired payback period is 5 years. Should Boeing purchase the new equipment?
- Total investment = $40,000
- Net annual cash inflow = Annual cash inflow – Annual cash outflow = $40,000 – $30,000 = $10,000
Answer will be –
= ($40,000 / $10,000)
Payback Period = 4 years
Hence, it may be settled that the equipment is desirable as its payback period of 4 years is less than Boeing’s maximum payback period of 5 years.
In the aforesaid examples, the various projects generated even cash inflows. What if the projects had generated uneven cash inflows? In such a scenario, payback period calculations are still simple! You just need to first find out the cumulative cash inflow and then apply the following formula to find the payback period.
Example #3
Suppose Microsoft Corporation is analyzing a project that requires an investment of $250,000. The project is expected to come up with the following cash inflows in five years.
Calculate the payback period of the investment. Also, find out whether the investment needs to be made if the management wants to recover the initial investment in 4 year-period?
Step 1
Calculation of cumulative net cash inflow –
Note: In the 4th year, we got the initial investment of $250,000, so this is the payback year.
Step 2
- Years before the full recovery takes place = 3
- Annual cash inflows during the payback year = $50,000
Calculation of not recovered investment at the beginning of the 4th year = Total investment – Cumulative cash inflows at the finish of the 3rd year = $250,000 – $210,000 = $40,000.
Therefore, Answer will be –
= 3 + ($40,000 / $50,000)
Payback Period = 3.8 years.
So, it can be concluded that the investment is desirable as the payback period for the project is 3.8 years, which is slightly less than the management’s desired period of 4 years.
#3 – Helps in Reducing the Risk Of losses
A project with a short payback period indicates efficiency and improves the liquidity position of a company. It additionally means the project bears less risk, which is significant for small enterprises with restricted resources. A brief payback period also curtails the risk of losses caused due to changes within the economic situation.
Example #4
There are two varieties of equipment (A and B) within the market. Ford Motor Company wants to know which one is more efficient. While equipment A would cost $21,000, equipment B would value $15,000. Both the equipment, by the way, has a net annual cash inflow of $3,000.
Thus, in order to find efficiency, we need to find which equipment has a shorter payback period.
Payback Period of Equipment A will be –
= $21,000/$3,000
Payback Period = 7 years
Payback Period of Equipment B will be –
= $15,000/$3,000
Payback Period = 5 years
Since equipment B has a shorter payback period, Ford Motor Company should consider equipment B over equipment A.
- Any investments with a short payback period to ensure that adequate funds are available soon to invest in another project.
Disadvantages
- It doesn’t take Time Value of MoneyTime Value Of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.read more into consideration. This method doesn’t consider the fact that a dollar today is way more valuable than a dollar promised in the future. For instance, $10,000 invested for a period of 10 years will become $100,000. However, even though the amount of $100,000 may look profitable today, it won’t be of the same value a decade later.
- The method additionally doesn’t take into consideration the inflow of cash after the payback period.
Example
The management of a firm is failing to understand which machine (X or Y) to buy as both of them need an initial investment of $10,000. But, machine X generates an annual cash inflow of $1,000 for 11 years, whereas machine Y generates a cash inflow of $1,000 for 10 years.
The answer will be –
Payback Period = 10 years
The answer will be –
Payback Period = 10 years
Therefore, just by looking at the annual cash inflow, it can be said that machine X is better than machine Y ($1,000 ∗ 11 > $1,000 ∗ 10). But, if we tend to apply the formula, the confusion remains as both the machines are equally desirable, given that they have the same payback period of 10 years ($10,000 / $1,000).
Summary
Despite its shortcomings, the method is one of the least cumbersome strategies for analyzing a project. It addresses simple requirements such as how much time period is needed to get back the invested money in a project. But, it’s true that it ignores the overall profitability of an investment because it doesn’t account for what happens after payback.
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