Question

Payback approach – What are the primary strengths and weaknesses of the payback approach in capital budgeting?

Requirements: 250 words

Answer 1

Payback approach is one of the method used to evaluate the investment and make decision on investment. Payback period refers to number of years it would take for the project to cover the cost of investment.

The primary strengths of payback approach are as follows

a. Payback approach is easy to calculate.

b. It helps to determine the project which provides faster return than other projects available.

c. It is beneficial in order to take initial screening of the projects where longer period payback projects can be rejected at early stage.

The primary weaknesses of payback approach are as follows

a. Payback approach does not consider time value of money and thus the payback period would be longer than actual discounted payback period

b. Payback period ignores the cash flows which are received after the payback period.

c. Since after payback period cash flow are ignored, the payback period will not help in deriving of correct decision. Even though the cash flows of other project are higher the investment would be rejected based on payback period.