Question

Describe the pay back method and briefly explain why it is used widely.

Answer 1

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Answer
Payback method is a project evaluation technique used in capital budgeting. The method calculates the length of the time that will be taken by a project to recover its initial investment.  

Payback period = Initial investment / Cash flow every year

Payback period (Uneven cash flows ) = A+B/C
where A is the time elapsed before the recovery year
B is the balance amount recovered in the recovery year
C is the cash flow in the recovery year .

Why is it used widely ?
a) Since payback period gives an estimate about the time by which the investment amount will be recovered , it helps in future cash and project management.

b) It is a very crucial criteria to choose a project when the business has liquidity problems.
c) Payback period is a very simple to use as it does not involve any discounting or complex formula .
d) IT helps in risk estimation .As the payback period increases the project becomes riskier and unreliable.
e) It can be easily used to compare two projects which have similar returns but different capital requirements.