The Payback Method

Disadvantages of the Payback Method

The payback period is considered a method of analysis with serious limitations and qualifications because it does not account for the time value of money, risk, financing, or other important considerations, such as opportunity cost.

While the time value of money can be rectified by applying a weighted average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation. Alternative measures of "return" economists prefer are net present value and internal rate of return. An implicit assumption in using a payback period is that returns to the investment continue after the payback period. The payback period does not specify any required comparison to other investments or not investing.

Tall, white buildings with red roofs line the waterfront. A blue car drives on the road in front of the buildings.

Zhuhai seafront development Payback is the amount of time it takes to return an initial investment; however, it does not account for the time value of money, risk, financing, or other important considerations, such as the opportunity cost.

Payback ignores the time value of money. For example, two projects are considered equally attractive if they have the same payback regardless of when the payback occurs. If both projects require an initial investment of $300,000, but Project 1 has a payback of one year and Project two of three years, the projects are viewed equally, although Project 1 is more valuable because additional interest could be earned on the funds in years two and three.

Payback also ignores the cash flows beyond the payback period, thereby ignoring the project's profitability. Thus, one project may be more valuable than another based on future cash flows, but the payback method does not capture this.

Additional complexity arises when the cash flow changes sign several times (i.e., it contains outflows in the midst or at the end of the project lifetime). The modified payback period algorithm may then be applied. First, the sum of all the cash outflows is calculated. Then, the cumulative positive cash flows are determined for each period. The modified payback period is calculated when the cumulative positive cash flow exceeds the total cash outflow.

Key Points

Payback ignores the time value of money.
Payback ignores cash flows beyond the payback period, thereby ignoring the "profitability" of a project.
To calculate a more exact payback period: Payback Period = Amount to be Invested/Estimated Annual Net Cash Flow.

Terms

Cost of Capital – the rate of return that capital could be expected to earn in an alternative investment of equivalent risk
Return – gain or loss from an investment.
Opportunity Cost – the cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.