Question

This week you started reading Module 6 and you were introduced to the concept of payback. Explain some of the potential pitfalls of using payback period in evaluating an investment decision. Some things to consider as you answer include these questions. Does the interest rate play a role? Why would a company choose payback over something like net present value in making a decision? What are the problems that are created in having so many options available to decision makers?

Answer 1

While evaluating the investment decision Payback period is very easy to understand and for calculating also but due to some reasons it is not the most optimum method to evaluate the investment decision some of them are:

It does not consider the time value of money as two projects could have the same payback period, but one project generates more cash flow in the early years, whereas the other project has higher cash flows in the later years.

It ignores the profitability of the project: if the payback period shown is shorter it clearly does not indicate that project will be more profitable.

Project's return on investment is not taken into consideration: Some companies require capital investments to exceed a certain rate of return; otherwise the project is declined. The payback method does not consider a project's rate of return.

The payback period refers to the amount of time it takes to recover the cost of an investment or how long it takes for an investor to reach breakeven. so no interest rate do not play any role in payback period thats why it does not consider time value of money.

Company should choose payback period over something else because its not time consuming, easy to calculate. NPV examine all positive and negative cash flows while payback period method is more convenient it calculate the time of reaching to project's breakeven.

Due to so many options are available it becomes difficult for the investors which method to choose because every method has its own pros & cons some method consider internal rate of return, some only time value other discounted cash flow, Accounting rate of return consider high rate of return etc. so it becomes difficult to analyse more optimum method for higher profitability.