Question

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Why is an investment more attractive to management if it has a shorter payback period?

Identify two disadvantages of using the payback period for comparing investments.

Answer 1

Payback period is the time required for an investment to recover the cost of investment. Which means the lenght of time by which project touches break-even point and after which profit is generated. Payback period is used as a technique for evaluation of an investment or operational project whether to to undertake the project or not.

  In payback period counting the number of years it takes to recover the funds invested fund help management to compare given potential investment opportunities. In comparing between different project on basis of payback period will be as per the length of payback period whether it is shorter or longer.

Longer payback period means the project need more years to return the initial investment. At the same time shorter implies lesser time needed to cover cost of investment.In most case management prefer a project with shorter payback period because it is the project which gives back shareholders money immediately than other. It is easy to explain the basis of selection of investment to the stakeholders as yield returns investment in lesser years.

Demerits of Payback Period

If we consider the packback period formula which is

"Payback Period = Initial Outlay/Cash Inflows"

It ignores Time Value of Money. The Value of Money throughout the life of project would not be the same. A discounted Payback Period overcomes this issue.

If we Consider the Calculation of Payback period it leads only until intial investment is covered so as to determine number of years. But it disregards the Cash flow that occurs after the payback period. So this method would not compare the profit potential of investment opportunities.