Payback period advantages and disadvantages inform investors how the technique can positively or negatively affect their capital budgeting.
Payback Period Advantages and Disadvantages
You could choose to payback period over other capital budgeting techniques because of its advantages. In other scenarios, you could avoid this technique because of its drawbacks. This guide dives deep into the pros and cons of this capital budgeting technique.
Advantages of Payback Period
1. Simple to Calculate
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.
2. Simple to use and understand
A few inputs are needed to help corporate managers make effective decisions important to the company’s growth. Results from payback period computation are simple to interpret. With shallow knowledge of project evaluation, one can identify the better project from viable alternatives.
3. Liquidity preference
Businesses need to have liquid capital in their day-to-day operations. Management must understand the right investments to pursue to keep liquidity in the business for more growth.
If you are a manager, the payback period technique will help you know where to commit the money and earn it back soon. In a nutshell, payback period helps you have a better control of both long term and long term business liquidity.
4. Useful in the event of uncertainty
Payback period method is useful in determining how fast there will be returns on investment. It measures the risk of different projects using potential years to recover the capital invested. 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.
5. Used for small investments
Small businesses generally have minimal funds to invest in their businesses. They can, however, use the limited funds wisely and choose the most effective project that will be profitable. These kinds of investments are important for business growth.
Disadvantages of Payback Period
1. It ignores the time value of money
By the time value of money, I mean considering inflation and its impact on currency purchasing power. The payback period completely disregards that fact and only focuses on the period it takes to return the investments.
As an investor, you could get a wrong impression from this method. You could accept a considerably long payback period and forget about inflation and money losing its value.
2. Not all cash flows are covered
Only short-term cash flow is considered; since the payback period only focuses on short-term capital budgeting, management will easily access important information required over a long period. Because different projects come with different cash flow schedules, making major decisions based on the payback period approach is quite hard.
3. It is Non-realistic
This is because of its simplicity; it fails to recognize everyday business scenarios. Some of these scenarios include irregular cash inflow.
When you start a project, returns could be higher or lower than predicted. These discrepancies are not taken care of in the payback period. Since a practical project will have these discrepancies, inferences from the payback period approach sometimes feel non-realistic.
4. Ignores profitability
Suppose a company gets a shorter payback period, which is the goal of the payback period. It does not necessarily mean the project will be profitable. Cash flows may stop once the payback period ends, making such a project meaningless.
You could end up ignoring to take a project that could have been profitable in the long run. The fact that a project has a longer payback period may force you to take another project that is way less profitable. This is why you should combine the payback period technique with other capital budgeting methods to visualize a project’s earned value in the future.
5. Too simple for most investments
Most business investments are complex, and many factors have to be considered. The payback period is too simple for most of these investments since it does not account for most factors. Your project could be a portfolio and not necessarily a single target mission kind of a project.
6. No in-depth assessments are done on the investments
Since the payback period focuses mainly on short-term projects, management may put minimal focus on long-term projects. This will lead to the partial abandonment of long-term projects that will not get the necessary attention.