As businesses grow and expand, managers are faced with a challenge of choosing a project that can warrant a further investment. Planning on how to allocate capital is a very important skill that managers should learn to avoid spending money on unyielding investments as this will be a wastage of capital. Payback period is a capital management concept which refers to a certain period of time which will be required for a project to generate revenue that will cover the initial revenues invested by the company during the start of that project. For instance, if the initial capital used to start the project was $60000 and the revenue that the project is bringing in each year is $20000 then that means that the payback period of that project would be 3 years.
The choice between two or more investments regarding which one to go with is usually the one with the shortest payback period. This is determined by simply dividing the amount used to start the project and the amount that the project is generating per year. A project with shorter payback period implies higher returns. Numerous companies have maximum acceptable payback period however when they decide on which investment to go with, they will consider projects with less payback period than them. So, what are the advantages and disadvantages of payback period?
Advantages Of Payback Period
The method is popularly used by business analysts because of several reasons;
1. It Is Simple
A significant percentage of companies use employees with different backgrounds to analyze capital projects which is not only biased but a difficult process to understand. On the other hand, payback method looks at the number of years which make it simple and easy to understand.
2. Offers Quick Evaluation
Determining which projects can generate fast returns is important to companies especially those with limited resources. Managers of such companies use this method to make a quick evaluation regarding projects with the small investment and short payback period.
Other benefits include:
- The term is universal hence can be understood by anyone.
- It shows the importance of considering liquidity when making investment decisions.
- It offers the shortest approach to calculating capital expenditure.
Disadvantages Of Payback Method
1. Ignores Time Value of Money
The method ignores the time value of money. A project’s cash inflow might be irregular. Investments are usually long term and continue to generate income even long after they have paid back their initial start-up capital. However, if a project has a long payback period it gets overlooked.
Other disadvantages include:
- The method emphasizes on liquidity rather than profitability.
- Only cash returns within the period are considered.