Question

Why should the payback method of analyzing capital purchases never be used as the sole basis for decision making?

Answer 1

The payback method is used to evaluate capital projects by calculating the payback period. The payback period denotes the length of time that is required to recover the initial amount invested in the capital project and it is computed by dividing the initial investment by the annual net cash inflow. The shorter the payback period, the more desirable is the capital purchase. Though the payback method is a simple method for evaluating capital purchases, the same should never be used as the sole basis for decision making due to its limitations.

The payback method fails to consider the time value of money by discounting cash flows that occur at different points of time. It also ignores the cash flows occurring beyond the payback period thereby rejecting capital purchases which may generate substantial cash inflows in later years. This method also measures a project’s capital recovery but not its profitability.

Due to the above mentioned limitations, the payback method must be used along with other methods of evaluating capital investments such as the accounting rate of return, net present value, profitability index, and internal rate of return.