Question

What is the payback period, how is it calculated, what weaknesses are commonly associated with the use of the payback period to evaluate a proposed investment?

PLEASE MINIMUM 350 word.

Answer 1

Payback Period:- Payback period is time span in which investor got back his invested money. It is a technique of capital budgeting to compare difference project at the same time. It is important period and pay major role in decision making to undertake the project or not. As if a project takes too much time for payback it may be ignored. It is simple to calculate, as it counts no years in which project return its invested money. Many financial experts use it as additional reference for analysis.

How to calculate payback period

Formula:-

Payback Period= Total Cash outflow/Net Cash inflow every year

Or

Payback Period= Total invested amount/Annual cash inflow

Weakness of Payback period:- Analysis of payback period is method of serious shortcoming, limitations and qualification to use. Decision taken only on the basis of payback period is very serious matter may times. Some weakness discussed here :-

1. It does not use concept of time value of money due to this sometimes it give inappropriate results.
2. Same treatment given to every Cash flow, whether cash flow done in beginning, mid or end of year.
3. It does not take cognizance of cash generated by a project after return of invested amount. It always focus on short payback period of project due to this it ignore many time valuable projects having long span of return.
4. Does not take care of risk involved in projects.
5. It also not considers opportunity cost of projects in valuation.
6. Mode of finance and its cost also not part of payback period.

How to overcome from shortcomings of Payback Period

1. Use of weighted average method with cash flow.
2. Use of Discounted cash flow instead of simple cash flow.
3. Use of Cash flow after the completion of project or return on invested capital.

Despite above shortcomings it is useful due to its easiness to understand. It can be used without academic qualification, training and other tools. Every common person understands need of liquidity, much money in hand will have same can be invested to other projects as well. To get better results payback period will always be in picture.