Question

With capital budgeting, one method that is the simplest but stands out among others is the payback method. What makes this method different than the others and why is the method inferior to the others?

Answer 1

One of the methods of Capital budgeting is Payback period method which helps in determining how long it will take to recover the initial investment made. By using the formula of (Initial investment / Cash inflow per year), we can determine the number of years needed to recover initial investment. And this is the reason why it is also known as the simplest of others, because the main thing that any investor needs to know among other is how quickly he can recover his investment and Payback period does that only. It helps in comparison of different available investment oppurtunities and choosing the one with the shortest Payback period.

However, there are certain drawbacks of Payback period as well which makes it inferior to the others, they are as follows:
1- Time value of money is ignored in Payback period. We all know that money received in present has more value than same money received in a future date, because it can be invested today and some interest cound have been earned on it. Payback period method ignores time value of money and compares investments based only on how quickly initial investment is recovered.
2- Payback period method is concerned only about the initial investment and does not regard to cash flows after the recovery. There may be case when cash flows increases after the initial investment is recoverd but this fact is not considered by Payback method.
3- Payback period method also does not take profitability in regard which is the main purpose why an individual invests in a project. Projects which have low initial cash flows but high profitability in future are not shown if we use Payback period.
4- Payback period also does not consider a project's rate of return, which is a limitation for companies who require capital investment to exceed a certain hurdle of rate of return.
Despite it's simplicity, because of the demerits mentioned above, Payback period method is inferior to other methods.

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