Question

Payback period is one of the techniques discussed for assessing which projects a firm should invest in. In finance we generally frown upon it, believing there are a number of better approaches to choose from. Despite this fact, businesses (especially historically) often use payback period. What are some of the drawbacks to this technique? Illustrate with an example of how these drawbacks could lead one to a poor decision if payback period is used.

Answer 1

The drawbacks of payback period of that it does not consider time value of minet. Cash flows received in the early years of a project get a higher weight than cash flows received in the later years. There might be two projects having same payback period but one might have higher cash flows in the earlier and the other one in the later years. It also neglects the cash flows received after the payback period. Projects having higher payback period might have higher returns on investment. Shorter payback period doesn't mean that the project will be profitable.

Among all of this the major disadvantage is that it do not take into account the time value of money..

For example an inflow of 15000 from an investment that occurs in the fifth year following the investment is viewed as having the same value as a 15000 cash outflow that occured in the year the investment was made despite the fact that the purchasing power of 15000 is significantly lower after 5 years.